Th e First National Bank of Great Falls is considering a leveraged lease agreement involving some mining equipment with the Big Sky Mining Corporation. Th e bank (40 percent tax bracket) will be the lessor; the mining company, the lessee (0 percent tax bracket); and a large California pension fund, the lender. Big Sky is seeking $50 million, and the pension fund has agreed to lend the bank $40 million at 10 percent. Th e bank has agreed to repay the pension fund $4 million of principal each year plus interest. (Th e remaining balance will be repaid in a balloon payment at the end of the fifth year.) Th e equipment will be depreciated on a straight-line basis over a 5-year estimated useful life with no expected salvage value. Assuming that Big Sky has agreed to annual lease payments of $10 million, calculate the bank’s initial cash outflow and its first two years of cash inflows.
To calculate the bank's initial cash outflow and its first two years of cash inflows, we need to consider the lease payments, the loan repayment, and the depreciation.
1. Initial Cash Outflow:
The bank's initial cash outflow is the amount it needs to lend to Big Sky Mining Corporation. Since Big Sky is seeking $50 million, the bank will lend them this amount. Therefore, the initial cash outflow is $50 million.
2. Cash Inflows - Year 1:
In Year 1, the bank will receive lease payments from Big Sky and will also have to make loan repayments to the pension fund.
Lease Payments: Big Sky has agreed to annual lease payments of $10 million. Since the bank is the lessor, it will receive this amount. Therefore, the cash inflow from lease payments in Year 1 is $10 million.
Loan Repayments: The bank has agreed to repay the pension fund $4 million of principal each year plus interest. Since the loan amount is $40 million and the interest rate is 10%, the interest payment in Year 1 is 10% of $40 million, which is $4 million. Therefore, the total loan repayment in Year 1 is $4 million of principal plus $4 million of interest, which is $8 million.
The net cash inflow in Year 1 is the lease payment minus the loan repayment, which is $10 million - $8 million = $2 million.
3. Cash Inflows - Year 2:
In Year 2, the bank will again receive lease payments from Big Sky and will have to make loan repayments to the pension fund.
Lease Payments: The lease payments remain the same at $10 million per year. Therefore, the cash inflow from lease payments in Year 2 is also $10 million.
Loan Repayments: The bank has agreed to repay the pension fund $4 million of principal each year plus interest. As the bank repays $4 million of principal each year, the remaining loan balance after Year 1 is $40 million - $4 million = $36 million. Therefore, the interest payment in Year 2 is 10% of $36 million, which is $3.6 million. The total loan repayment in Year 2 is $4 million of principal plus $3.6 million of interest, which is $7.6 million.
The net cash inflow in Year 2 is the lease payment minus the loan repayment, which is $10 million - $7.6 million = $2.4 million.
In summary:
- Initial cash outflow: $50 million
- Cash inflow - Year 1: $2 million
- Cash inflow - Year 2: $2.4 million