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CHAPTER 19 LEASE FINANCING

(Difficulty: E = Easy, M = Medium, and T = Tough)

True/False Easy:
(19.1) Types of leases Answer: a Diff: E 1 . Many leases written today combine the features of operating and financial leases. Such leases are often called combination leases. a. True b. False (19.1) Types of leases Answer: a Diff: E 2 . A sale and leaseback arrangement is a type of financial, or capital, lease. a. True b. False (19.1) Operating lease Answer: a Diff: E 3 . Operating leases help to shift the risk of obsolescence from the user to the lessor. a. True b. False (19.1) Sale and leaseback Answer: a Diff: E 4 . Under a sale and leaseback arrangement, the seller of the leased property is the lessee and the buyer is the lessor. a. True b. False (19.2) Lease payments Answer: a Diff: E 5 . The full amount of a lease payment is tax deductible provided the contract qualifies as a true lease under IRS guidelines. a. True b. False

Chapter 19: Lease Financing

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(19.3) Off-balance sheet leasing Answer: a Diff: E 6 . Leasing is often referred to as off-balance sheet financing because lease payments are shown as operating expenses on a firm's income statement and, under certain conditions, leased assets and associated liabilities do not appear on the firm's balance sheet. a. True b. False (19.4) Lease financing Answer: b Diff: E 7 . Leasing is typically a financing decision and not a capital budgeting decision. Thus, the availability of lease financing cannot affect the size of the capital budget. a. True b. False (19.5) Leveraged lease Answer: b Diff: E 8 . A leveraged lease is more risky from the lessees standpoint than an unleveraged lease. a. True b. False

Medium:
(19.1) Synthetic leases Answer: b Diff: M 9 . A synthetic lease is a combination of derivative securities and asset purchases that mimic the cash flows of an operating lease. a. True b. False (19.1) Synthetic leases Answer: a Diff: M 10 . In a synthetic lease a special purpose entity (SPE) is set up by a corporation that wants to acquire the use of an asset. The SPE borrows up to 97% of its capital, uses its funds to buy the asset, and then leases it to the sponsoring corporation on a short-term basis. This keeps both the asset and the debt off the sponsoring companys books. a. True b. False (19.6) Residual value and lease rates Answer: b Diff: M 11 . If a leased asset has a negative residual value, for example, as a result of a statutory requirement to dispose of an asset in an environmentally sound manner, the lessee of the asset could reasonably expect to pay a lower lease rate because the asset does not have a positive residual value. a. True b. False

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Chapter 19: Lease Financing

(19.6) Residual value and lease rates Answer: b Diff: M 12 . Assume that a piece of leased equipment has a relatively high rather than low expected residual value. From the lessee's viewpoint, it might be better to own the asset rather than lease it because with a high residual value the lessee will likely face a higher lease rate. a. True b. False

Multiple Choice: Conceptual Easy:


(19.4) Lease cash flows Answer: c Diff: E 13 . From the lessee viewpoint, the riskiness of the cash flows, with the possible exception of the residual value, is about the same as the riskiness of the lessee's a. b. c. d. e. equity cash flows. capital budgeting project cash flows. debt cash flows. pension fund cash flows. sales.

Medium:
(19.1) Operating lease 14 . Operating leases often have terms that include a. b. c. d. e. Answer: a Diff: M

maintenance of the equipment by the lessor. full amortization over the life of the lease. very high penalties if the lease is cancelled. restrictions on how much the leased property can be used. much longer lease periods than for most financial leases.

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(19.1) Leasing 15 . Which of the following statements is most CORRECT?

Answer: e

Diff: M

a. Firms that use "off balance sheet" financing, such as leasing, would show lower debt ratios if the effects of their leases were reflected in their financial statements. b. Capitalizing a lease means that the firm issues equity capital in proportion to its current capital structure, in an amount sufficient to support the lease payment obligation. c. The fixed charges associated with a lease can be as high as, but never greater than, the fixed payments associated with a loan. d. Capital, or financial, leases generally provide for maintenance by the lessor. e. A key difference between a capital lease and an operating lease is that with a capital lease, the lease payments provide the lessor with a return of the funds invested in the asset plus a return on the invested funds, whereas with an operating lease the lessor depends on the residual value to realize a full return of and on the investment. (19.3) Capitalizing leases Answer: c Diff: M 16 . Financial Accounting Standards Board (FASB) Statement #13 requires that for an unqualified audit report, financial (or capital) leases must be included in the balance sheet by reporting the a. residual value as a fixed asset. b. residual value as a liability. c. present value of future lease payments as an asset and also showing this same amount as an offsetting liability. d. undiscounted sum of future lease payments as an asset and as an offsetting liability. e. undiscounted sum of future lease payments, less the residual value, as an asset and as an offsetting liability. (19.3) Off-balance sheet leasing Answer: b 17 . Heavy use of off-balance sheet lease financing will tend to Diff: M

a. make a company appear more risky than it actually is because its stated debt ratio will be increased. b. make a company appear less risky than it actually is because its stated debt ratio will appear lower. c. affect a company's cash flows but not its degree of risk. d. have no effect on either cash flows or risk because the cash flows are already reflected in the income statement. e. affect the lessees cash flows but only due to tax effects.

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Chapter 19: Lease Financing

(19.4) Lease decision Answer: e 18 . In the lease versus buy decision, leasing is often preferable

Diff: M

a. because it has no effect on the firm's ability to borrow to make other investments. b. because, generally, no down payment is required, and there are no indirect interest costs. c. because lease obligations do not affect the firms risk as seen by investors. d. because the lessee owns the property at the end of the least term. e. because the lessee may have greater flexibility in abandoning the project in which the leased property is used than if the lessee bought and owned the asset. (19.4) Lease analysis discount rate Answer: c Diff: M 19 . A lease versus purchase analysis should compare the cost of leasing to the cost of owning, assuming that the asset purchased a. b. c. d. is financed with short-term debt. is financed with long-term debt. is financed with debt whose maturity matches the term of the lease. is financed with a mix of debt and equity based on the firms target capital structure, i.e., at the WACC. e. is financed with retained earnings.

Multiple Choice: Problems Easy:


(19.4) Difference in payments Answer: c Diff: E 20 . Sutton Corporation, which has a zero tax rate due to tax loss carryforwards, is considering a 5-year, $6,000,000 bank loan to finance service equipment. The loan has an interest rate of 10% and would be amortized over 5 years, with 5 end-of-year payments. Sutton can also lease the equipment for 5 end-of-year payments of $1,790,000 each. How much larger or smaller is the bank loan payment than the lease payment? Note: Subtract the loan payment from the lease payment. a. b. c. d. e. $177,169 $196,854 $207,215 $217,576 $228,455

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Medium:
(19.4) Net advantage to leasing (NAL) Answer: b Diff: M 21 . Kohers Inc. is considering a leasing arrangement to finance some manufacturing tools that it needs for the next 3 years. The tools will be obsolete and worthless after 3 years. The firm will depreciate the cost of the tools on a straight-line basis over their 3-year life. It can borrow $4,800,000, the purchase price, at 10% and buy the tools, or it can make 3 equal end-of-year lease payments of $2,100,000 each and lease them. The loan obtained from the bank is a 3-year simple interest loan, with interest paid at the end of the year. The firm's tax rate is 40%. Annual maintenance costs associated with ownership are estimated at $240,000, but this cost would be borne by the lessor if it leases. What is the net advantage to leasing (NAL), in thousands? (Suggestion: Delete 3 zeros from dollars and work in thousands.) a. b. c. d. e. $96 $106 $112 $117 $123

Tough:
(19.4) Lessee's analysis Answer: d Diff: T 22 . Dakota Trucking Company (DTC) is evaluating a potential lease for a truck with a 4-year life that costs $40,000 and falls into the MACRS 3year class. If the firm borrows and buys the truck, the loan rate would be 10%, and the loan would be amortized over the trucks 4-year life, so the interest expense for taxes would decline over time. The loan payments would be made at the end of each year. The truck will be used for 4 years, at the end of which time it will be sold at an estimated residual value of $10,000. If DTC buys the truck, it would purchase a maintenance contract that costs $1,000 per year, payable at the end of each year. The lease terms, which include maintenance, call for a $10,000 lease payment (4 payments total) at the beginning of each year. DTC's tax rate is 40%. Should the firm lease or buy? (Note: MACRS rates for Years 1 to 4 are 0.33, 0.45, 0.15, and 0.07.) a. b. c. d. e. $849 $896 $945 $997 $1,047

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(19.4) Lessee's analysis Answer: a Diff: T 23 . Busters Beverages is negotiating a lease on a new piece of equipment that would cost $100,000 if purchased. The equipment falls into the MACRS 3-year class, and it would be used for 3 years and then sold, because the firm plans to move to a new facility at that time. The estimated value of the equipment after 3 years is $30,000. A maintenance contract on the equipment would cost $3,000 per year, payable at the beginning of each year. Alternatively, the firm could lease the equipment for 3 years for a lease payment of $29,000 per year, payable at the beginning of each year. The lease would include maintenance. The firm is in the 20% tax bracket, and it could obtain a 3-year simple interest loan, interest payable at the end of the year, to purchase the equipment at a before-tax cost of 10%. If there is a positive Net Advantage to Leasing the firm will lease the equipment. Otherwise, it will buy it. What is the NAL? a. b. c. d. e. $5,736 $6,023 $6,324 $6,640 $6,972

Chapter 19: Lease Financing

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CHAPTER 19 ANSWERS AND SOLUTIONS

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Chapter 19: Lease Financing

1.(19.1) Types of leases 2.(19.1) Types of leases 3.(19.1) Operating lease 4.(19.1) Sale and leaseback 5.(19.2) Lease payments 6.(19.3) Off-balance sheet leasing 7.(19.4) Lease financing 8.(19.5) Leveraged lease 9.(19.1) Synthetic leases 10.(19.1) Synthetic leases 11.(19.6) Residual value and lease rates 12.(19.6) Residual value and lease rates 13.(19.4) Lease cash flows 14.(19.1) Operating lease 15.(19.1) Leasing 16.(19.3) Capitalizing leases 17.(19.3) Off-balance sheet leasing 18.(19.4) Lease decision 19.(19.4) Lease analysis discount rate

Answer: a Answer: a Answer: a Answer: a Answer: a Answer: a Answer: b Answer: b Answer: b Answer: a Answer: b Answer: b Answer: c Answer: a Answer: e Answer: c Answer: b Answer: e Answer: c

Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: M Diff: M Diff: M Diff: M Diff: E Diff: M Diff: M Diff: M Diff: M Diff: M Diff: M

20.(19.4) Difference in payments Years: 5 Loan amount: $6,000,000 Interest rate: 10.0% Lease Pmt: $1,790,000 0 Loan: -$6,000,000 1 PMT 2 PMT 3 PMT 4 PMT

Answer: c

Diff: E

5 PMT

Find the loan payment: Financial calculator solution: Inputs: N = 5; I/YR = 10; PV = -6,000,000; FV = 0. Output = PMT = $1,582,785 Difference in payments = $1,790,000 $1,582,785 = $207,215. 21.(19.4) Net advantage to leasing (NAL) Years: Loan amount = equipment cost: Interest rate: Lease Pmt: 3 $4,800 10.0% $2,100 Tax rate: Maintenance costs: Salvage value: Answer: b Diff: M

40% $240 $0

After tax cost of debt = Rate (1 T) = 6.0% Depreciation per year = Cost/3 = $1,600 Tax saving from deprn = Deprn T = $640 0 Cost of owning: Interest Interest tax saving Maintenance Maintenance tax saving Deprn tax saving Repayment of loan Net cash loan costs PV cost of owning (6%): Cost of leasing: Lease payment Tax savings from lease Net cash lease costs PV cost of leasing (6%): 1 -480 192 -240 96 640 208 -3,474 -2,100 840 -1,260 -3,368 -2,100 840 -1,260 -2,100 840 -1,260 2 -480 192 -240 96 640 208 3 -480 192 -240 96 640 -4,800 -4,592

NAL = PV Cost of Owning PV Cost of Leasing = $106.

22.(19.4) Lessee's analysis Life of equipment: Loan amount = equipment cost: Interest rate: 4 $40,000 10.0% Tax rate: Maintenance costs: Salvage value:

Answer: d 40% $1,000 $10,000

HARD

Lease Pmt:

$10,000

Loan amortization for cash payment and interest expense: Payment: N = 4, I/YR = 10, PV = 40000, FV = 0. PMT = -$12,618.83 Year 1 2 3 4 Loan Analysis: MACRS factor Depreciation Loan Pmt Int tax saving (Int. from table T)) Maintenance Maint. tax saving (Maint. T) Depr'n tax saving (Deprn T) Net operating CF Salvage value Tax on residual Net residual val Total Net CF PV cost of buying at I(1 T) = 6.00% Lease Analysis: Lease payment Tax saving on pmt Net cost of lease PV cost of leasing at I(1 T) NAL = $997 -23,035 0 -10,000 4,000 -6,000 -22,038 1 -10,000 4,000 -6,000 2 -10,000 4,000 -6,000 3 -10,000 4,000 -6,000 4 0 0 0 Beg. Bal. 40,000 31,381 21,900 11,472 PMT 12,619 12,619 12,619 12,619 0 Interest 4,000 3,138 2,190 1,147 Principal 8,619 9,481 10,429 11,472 1 0.33 13,200 -12,619 1,600 -1,000 400 5,280 -6,339 Ending Bal. 31,381 21,900 11,472 0 3 0.15 6,000 -12,619 876 -1,000 400 2,400 -9,943 4 0.07 2,800 -12,619 459 -1,000 400 1,120 -11,640 10,000 -4,000 6,000 -5,640

2 0.45 18,000 -12,619 1,255 -1,000 400 7,200 -4,764

-6,339

-4,764

-9,943

23.(19.4) Lessee's analysis Life of equipment: Loan amount = equipment cost: Interest rate, simple: Lease Pmt: Loan Analysis: MACRS factor Depreciation 3 $100,000 10.0% $29,000 0 Tax rate: Maintenance costs: Salvage value: 1 0.33 33,000 2 0.45 45,000

Answer: a 20% $3,000 $30,000 3 0.15 15,000

HARD

Totals 0.93 93,000

Loan repayment Interest Int tax saving (Interest T)) Maintenance -3,000 Maint. tax saving (Maint. T) 600 Depr'n tax saving (Deprn T) Net operating CF -2,400 Salvage value before taxes Book value (Cost Total dep'rn) Taxable salvage value Tax on salvage value Salvage value after taxes Total Net CF - 2,400 PV cost at I(1 T) = 8.00% -70,308 Lease Analysis: Lease payment Tax saving on pmt Net cost of lease PV cost of leasing at I(1 T) NAL = $5,736 0 -29,000 5,800 -23,200 -64,572

-10,000 2,000 -3,000 600 6,600 -3,800

-10,000 2,000 -3,000 600 9,000 -1,400

-100,000 -10,000 2,000

-3,800 1 -29,000 5,800 -23,200

-1,400 2 -29,000 5,800 -23,200

3,000 -105,000 30,000 7,000 23,000 -4,600 25,400 -79,600 3 0 0