The First National Bank of Springer has established a leasing subsidiary. A local firm, Allied Business Machines, has approached the bank to arrange lease financing for $10 million in new machinery. The economic life of the machinery is estimated to be 20 years. The estimated salvage value at the end of the 20-year period is $0. Allied Business Machines has indicated a willingness to pay the bank $1 million per year at the end of each year for 20 years under the terms of a financial lease.
a. If the bank depreciates the machinery on a straight-line basis over 20 years to a $0 estimated salvage value and has a 40 percent marginal tax rate, what after-tax rate of return will the bank earn on the lease?
b. In general, what effect would the use of MACRS depreciation by the bank have on the rate of return it earns from the lease?