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Exam 15: Lease Financing

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Question 1

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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

E) B) and C)
F) C) and D)

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Question 2

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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.

E) A) and B)
F) A) and C)

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Question 3

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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?

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.)

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

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.

When will a lower lease payment possibly arise?

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

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

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.)

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

Which statement best describes leases?

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.

Under which circumstances should an asset be leased?

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

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.

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

Which of the following best describes combination leases?

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.)

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