Deck 15: Lease Financing

Question 1

Which statement best describes leases?

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)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 on the investment.

Answer 1

D

Question 2

CCA recapture or terminal losses will not be an issue for lessors even when the lease expires.

Answer 2

True

Question 3

The full amount of a lease payment is tax deductible provided the contract qualifies as a true lease under CRA guidelines.

Answer 3

True

Question 4

Because of down payments,it is cheaper for lessees to lease an asset than to borrow money and purchase the asset.

Question 5

Which type of organization are Xerox and IBM good examples of?

A)firms specializing in lease financing
B)firms using only leases for asset financing
C)manufacturers of items that are financed exclusively by firms specializing in lease financing
D)manufacturers providing lease financing as part of their regular sales effort

Question 6

A synthetic lease is a combination of derivative securities and asset purchases that mimic the cash flows of an operating lease.

Question 7

The after-tax cost of debt is used as the discount rate for leasing analysis,and to be consistent with the capital budgeting purposes.

Question 8

Under International Accounting Standards IAS 17,a capital lease exists if the lease term is equal to 50% or less of the estimated economic life of the property.

Question 9

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.

Question 10

From the lessee viewpoint,the riskiness of the cash flows,with the possible exception of the residual value,is about the same as which of the following?

A)the lessee's equity cash flows
B)the lessee's capital budgeting project cash flows
C)the lessee's debt cash flows
D)the lessee's pension fund cash flows

Question 11

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.

Question 12

By entering into a lease,the lessee incurs an opportunity cost equal to the foregone CCA tax shield provided by the CCA of the asset.

Question 13

A fully taxable recapture exists if the lease provides the lessee with an option to purchase the asset at a bargain price.

Question 14

A lease has big impacts on the balance sheet,not the income statement.

Question 15

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.

Question 16

Which type of terms are often included in operating leases?

A)terms including maintenance of the equipment by the lessor
B)terms including full amortization over the life of the lease
C)terms including very high penalties if the lease is cancelled
D)terms including restrictions on how much the leased property can be used

Question 17

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 company's books.

Question 18

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.

Question 19

Under a sale and leaseback arrangement,the seller of the leased property is the lessee and the buyer is the lessor.

Question 20

A leveraged lease is more risky from the lessee's standpoint than an unleveraged lease.

Question 21

Which of the following statements is true?

A)Being the legal owners, lessors can claim full CCA for all assets.
B)Even with ownership, lessors may claim full CCA on exempt assets only.
C)As agreed, lessees are allowed to claim the CCA and the lease payment.
D)The specified leasing property rules discriminate against lessees for non-exempt assets.

Question 22

Kohers Inc.is considering a leasing arrangement to finance some manufacturing tools that it needs for the next three 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? (Hint: Delete 3 zeros from dollars and work in thousands.)

A)$96
B)$106
C)$112
D)$117

Question 23

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 five end-of-year payments.Sutton can also lease the equipment for five end-of-year payments of $1,790,000 each.How much larger or smaller is the bank loan payment than the lease payment? (Hint: Subtract the loan payment from the lease payment.)

A)$177,169
B)$196,854
C)$207,215
D)$217,576

Question 24

Consider the following information: original investment = $3,500,PV of CCA tax shield = $1,850,PV of after-tax lease payments = $2,000.What is the NAL?

A)$2,550
B)$1,650
C)-$800
D)-$350

Question 25

Which of the following is NOT a typical design of a synthetic lease?

A)A lender receives part of the lease payments from the lessee.
B)A lender is involved for a large part of the financing of the asset.
C)There is usually a long-term commitment.
D)It is a tax-oriented lease.

Question 26

If a lease is capitalized,how is it reported under International Accounting Standards IAS 17?

A)It shows up as a liability on the lessor's financial statements.
B)It is a debt on the right-hand side of the lessee's balance sheet, and an asset on the left.
C)The lease's present value shows as a liability on the lessee's balance sheet, but not as an asset.
D)The lease becomes a capital asset for the lessor, allowing the firm to capitalize on its value to borrow more.

Question 27

In theory,we may regard the lease alternative as a commitment to finance the asset with what level of debt?

A)0%
B)25%
C)50%
D)100%

Question 28

ABC LeasingABC Leasing has an after-tax cost of borrowing of 10%. The company is in a 35% tax bracket. A new machine will be purchased for $100,000. The straight-line method is used to calculate depreciation. With heavy use, the salvage value is zero. The firm now wants to rent out this machine for 5 years at a required return of 15%. The first lease payment starts once the contract has been signed. Furthermore, lease payments received by the lessor are fully taxable.
Refer to Scenario: ABC Leasing.What is the net cost of this machine for the lessor as a legal owner receiving all tax benefits?

A)$19,057
B)$29,318
C)$73,465
D)$100,000

Question 29

Consider the following information: original investment = $2,500,PV of CCA tax shield = $850,PV of after-tax lease payments = $1,700.What is the NAL?

A)$2,550
B)$1,650
C)-$800
D)-$50

Question 30

International Accounting Standards IAS 17 requires that for an unqualified audit report,financial (or capital) leases must be included in the balance sheet.How should they be reported?

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

Question 31

Under which circumstances should an asset be leased?

A)when the NPV is positive and the NAL is also positive
B)when the NPV is positive but the NAL is negative
C)when the NPV is negative and the NAL is negative too
D)when the NPV is negative and the NAL is positive, but smaller than the NPV

Question 32

When should a lease-versus-purchase analysis compare the cost of leasing to the cost of owning?

A)assuming that the asset purchased is financed with short-term debt
B)assuming that the asset purchased is financed with long-term debt
C)assuming that the asset purchased is financed with debt whose maturity matches the term of the lease
D)assuming that the asset purchased is financed with retained earnings

Question 33

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 3-year class.If the firm borrows money to buy the truck,the loan rate would be 10%,and the loan would be amortized over the truck's 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? (Hint: Depreciation rates for Years 1 to 4 are 0.33,0.45,0.15,and 0.07.)

A)$849
B)$896
C)$945
D)$997

Question 34

In the lease versus buy decision,why is leasing often preferable?

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 firm's risk as seen by investors
D)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

Question 35

Which of the following best describes combination leases?

A)Combination leases combine the features of operating leases and financial leases.
B)Combination leases combine the features of operating leases and convertible debt.
C)Combination leases combine the features of operating leases and financial leverage.
D)Combination leases combine the features of operating and equity options.

Question 36

When will a lower lease payment possibly arise?

A)when there is a lower tax rate for the lessee
B)when there is a lower tax rate for the lessor
C)when there is a lower purchase cost for the asset
D)when there is a lower CCA tax shield

Question 37

Under which circumstances will a lessor likely charge higher lease rates?

A)if the lessor's tax rate increases
B)if the cost of borrowing increases
C)if the residual value of the asset increases
D)if the purchase price of the asset decreases

Question 38

What will heavy use of off-balance sheet lease financing tend to do?

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)affect the lessee's cash flows but only due to tax effects

Question 39

ABC LeasingABC Leasing has an after-tax cost of borrowing of 10%. The company is in a 35% tax bracket. A new machine will be purchased for $100,000. The straight-line method is used to calculate depreciation. With heavy use, the salvage value is zero. The firm now wants to rent out this machine for 5 years at a required return of 15%. The first lease payment starts once the contract has been signed. Furthermore, lease payments received by the lessor are fully taxable.
Refer to Scenario: ABC Leasing.What is the required annual lease payment that the lessor must charge?

A)$17,391
B)$21,915
C)$26,535
D)$29,318

Question 40

Buster's 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? (Hint: Depreciation rates for Years 1 to 3 are 0.33,0.45,and 0.15)

A)$5,736
B)$6,023
C)$6,324
D)$6,640

Question 41

Consider the following information: original investment = $1,900,PV of CCA tax shield = $1,000,PV of after-tax lease payments = $900.What is the NAL?

A)$2,550
B)$1,650
C)$0.00
D)-$350

Question 42

Which of the following describes a sales and leaseback arrangement?

A)A sale and leaseback arrangement is a type of operating lease.
B)A sale and leaseback arrangement is a type of buyback loan.
C)A sale and leaseback arrangement is a type of financial, or capital, lease.
D)A sale and leaseback arrangement is a type of asset-based loan.

Question 43

Which of the following explains the risk underlying an operating lease?

A)Operating leases help to shift the risk of obsolescence from the user to the lessor.
B)Operating leases help to shift the risk of obsolescence from the user to the lessee.
C)Operating leases help to balance the risk of obsolescence between the lessor and lessee.
D)Operating leases help to shift the risk of obsolescence from the lessor to the user (lessee).

Question 44

Consider the following information: original investment = $20,000,PV of CCA tax shield = $10,000,PV of after-tax lease payments = $15,900.What is the NAL?

A)$2,550
B)$1,650
C)$0.00
D)-$5,900

Question 45

Consider the following information: original investment = $5,000,PV of CCA tax shield = $3,500,PV of after-tax lease payments = $1,900.What is the NAL?

A)$550
B)$650
C)-$400
D)$350