CHAPTER 22
LEASING
Answers to Concepts Review and Critical Thinking Questions
1.
Some key differences are: (1) Lease payments are fully tax-deductible, but only the interest portion of the loan
is; (2) Lessee does not own the asset and cannot depreciate it for tax purposes; (3) In the event of a default,
lessor cannot force bankruptcy; and (4) Lessee does not obtain title to the asset at the end of the lease (absent
some additional arrangement).
2.
The less profitable one because leasing provides, among other things, a mechanism for transferring tax benefits
from entities that value them less to entities that value them more.
3.
Potential problems include: (1) Care must taken in interpreting the IRR (a high or low IRR is preferred
depending on the setup of the analysis); and (2) Care must be taken to ensure the IRR under examination is not
the implicit interest rate just based on the lease payments.
4.
a.
b.
c.
Leasing is a form of secured borrowing. It reduces a firm’s cost of capital only if it is cheaper than other
forms of secured borrowing. The reduction of uncertainty is not particularly relevant; what matters is the
NAL.
The statement is not always true. For example, a lease often requires an advance lease payment or
security deposit and may be implicitly secured by other assets of the firm.
Leasing would probably not disappear, since it does reduce the uncertainty about salvage value and the
transactions costs of transferring ownership. However, the use of leasing would be greatly reduced.
5.
A lease must be disclosed on the balance sheet if one of the following criteria is met:
1.
The lease transfers ownership of the asset by the end of the lease. In this case, the firm essentially owns
the asset and will have access to its residual value.
2.
The lessee can purchase the asset at a price below its fair market value (bargain purchase option) when
the lease ends. The firm essentially owns the asset, and will have access to most of its residual value.
3.
The lease term is for 75% or more of the estimated economic life of the asset. The firm basically has
access to the majority of the benefits of the asset, without any responsibility for the consequences of its
disposal.
4.
The present value of the lease payments is 90% or more of the fair market value of the asset at the start of
the lease. The firm is essentially purchasing the asset on an installment basis.
6.
In order for the CCRA to count a lease as valid, it must be for business purposes, not for tax avoidance. If there
is any clause which involves the lessee acquiring title to the property, then the CCRA does not consider it a
lease and no tax advantages are given. Specifically, a lease will be disallowed if:
1.
The lessee automatically acquires title to the property after payment of a specified amount in the form of
rentals.
2.
The lessee is required to buy the property from the lessor during or at the termination of the lease.
3.
The lease should not contain a bargain purchase option, which the CCRA interprets as an equity interest
in the asset.
7.
As the term implies, off-balance sheet financing involves financing arrangements that are not required to be
reported on the firm’s balance sheet. Such activities, if reported at all, appear only in the footnotes to the
statements. Operating leases provide off-balance sheet financing. For accounting purposes, total assets will be
lower and some financial ratios may be artificially high. Financial analysts are generally not fooled by such
practices. There are no economic consequences, since the cash flows of the firm are not affected by how the
lease is treated for accounting purposes.
8.
The lessee may not be able to take advantage of the depreciation tax shield and may not be able to obtain
favorable lease arrangements for “passing on” the tax shield benefits. The lessee might also need the cash flow
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from the sale to meet immediate needs, but will be able to meet the lease obligation from cash flows in the
future.
9.
Since the relevant cash flows are all after-tax, the after-tax discount rate is appropriate.
10. There is the tax motive, but, beyond this, the leasing company knows that, in the event of a default, Air Canada
would relinquish the planes which would then be re-leased. Tangible assets, such as planes, which can be
readily reclaimed and redeployed are good candidates for leasing.
11. They will be re-leased to Air Canada or another air transportation firm, or they will simply be sold. There is an
active market for used aircraft.
Solutions to Questions and Problems
Basic
1.
Tax shields are assumed to be claimed at the beginning of the year.
Year
Investment
Lease payment
Payment shield
Forgone tax shield
Total cash flow
0
$24,000
-9,000
3,600
-1,440
$17,160
1
2
3
-9,000
3,600
-2,448
-$7,848
-9,000
3,600
-1,714
-$7,114
-3,998
-$3,998
NAL6% = $67.99
Intermediate
2.
Assuming end of year lease payments:
I=$2,000,000, SV4=0, L=$600,000/yr., d = 30%, T = 33%, and r = 8%
The after-tax cost of debt is 8(1–.33) = 5.36%
PV of CCATS = 2,000,000(.3)(.33) x (1 + .5(.0536)) = $545,711
.0536 + .30
1 + .0536
NAL = 2,000,000 – 600,000(1–.33) x PVIFA (5.36%, 4) – 545,711 = $40,657
Therefore, the firm should lease the equipment.
3.
A gain for the lessee means a loss for the lessor = – $40,657
4.
NAL = 0 = $2,000,000 – X(PVIFA5.36%,4) – 545,711; X = $413,561.82 is the after-tax lease payment.
Before tax lease payment = $413,561.82/0.67 = $617,256.45
5.
If the tax rate is zero, there is no depreciation tax shield foregone, the after-tax lease payment is the same as
the pretax payment, and the after-tax cost of debt is the same as the pretax cost.
cost of debt = .08 annual cost of leasing = leasing payment = $600,000
NAL = $2,000,000 – $600,000(PVIFA8%,4) = $12,723.90
The lessor breaks even with a payment of $617,256.45 (from problem 4).
Lessee: breakeven payment — NAL = 0 = $2,000,000 – PMT(PVIFA8%,4) ; PMT = $603,841.61
Total payment range = $603,841.61 to $617,256.45
6.
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7.
Scanner cost=$2,000,000, SV4=0, Lease payment=$600,000/yr., d=50%, T=33%, and r=8%
The after-tax cost of debt is 8(1–.33) = 5.36%
PV of CCATS = 2,000,000(.5)(.33) x (1 + .5(.0536)) = 580,935.55
.0536 + .5
1 + .0536
NAL = 2,000,000 – 600,000(1– .33) x PVIFA (5.36%, 4) – 580,935.55 = $5,432.56
Therefore, the firm should lease the equipment.
8.
The pretax cost savings are not relevant to the lease versus buy decision, since the firm will definitely use
the equipment and realize the savings regardless of the financing choice made. The forgone salvage value
is a cost to the lease decision and the lost tax shield on the resale represents a gain to the lease decision.
Also, the salvage value is not really a debt-like cash flow, since there is uncertainty associated with it at
year 0. Nevertheless, although a higher discount rate may be appropriate, we’ll use the after tax cost of debt
to discount the residual value as is common in practice.
After-tax cost of debt = .09(1 – .34) = .0594
PV of CCATS = 5,500,000(.25)(.34) x (1 + .5(.0594)) – 500,000(.25)(.34) x
1
.0594 + .25
1 + .0594
.0594 + .25
(1 + .0594) 5
= 1,365,692.48
After-tax lease payment = $1,240,000(1 – .34) = $818,400
NAL = $5.5M – $818,400(1.0594)(PVIFA5.94%, 5) – 1,365,692.48 – 500,000 (PVIF5.94%, 5) = $101,476.23
The equipment should be leased.
Maximum payment:
NAL = 0 = $5.5M – $X(1.0594)(PVIFA5.94%, 5) – 1,365,692.48 – 500,000 (PVIF5.94%, 5)
X = $841,102.27
pretax lease payment = $841,102.27/(1 – .34) = $1,274,397.38
9.
PV of CCATS = 5,500,000(.25)(.34) x (1 + .5(.0594)) = 1,468,628.83
.0594 + .25
1 + .0594
NAL = 0 = $5.5M – $X(1.0594)(PVIFA5.94%, 5) – 1,468,628.83
X = $901,898.64
pretax lease payment = $901,898.64/(1 – .34) = $1,366,513.09
10.
The security deposit of $200,000 reduces the initial benefit of leasing (not having to pay $5.5M upfront for
the system) and reduces the foregone benefit of the salvage value by the same amount when it is returned at
the end of the fifth year.
NAL = $5.3M – $818,400(1.0594)(PVIFA5.94%, 5) – 1,365,692.48 – 300,000 (PVIF5.94%, 5) = $51,351.56
Even with the security deposit, the firm should lease the equipment since the NAL is greater than zero.
Challenge
11.
loan amount = $2,000,000 = PMT(PVIFA8%,4) ; PMT = $603,841.61
PV after-tax payment = PV(payment – interest tax shield):
year 1: PV($603,841.61 – ($2,000,000.00)(.08)(.33)) = $551,041.61/1.0536
year 2: PV($603,841.61 – ($1,556,158.39)(.08)(.33)) = $562,759.03/1.05362
year 3: PV($603,841.61 – ($1,076,809.45)(.08)(.33)) = $575,413.84/1.0536 3
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year 4: PV($603,841.61 – ($559,112.60)(.08)(.33)) = $589,081.04/1.0536 4
NAL = 2,000,000 – 600,000(1 – .33) x PVIFA (4, 5.36%) – 545,711 = $40,657
The NAL is the same because the present value of the after tax loan payments, discounted at the after tax
cost of capital (which is the after tax cost of debt) equals $2,000,000.
12. Rework the problem using the net value of the investment in the tax shield section of the equation:
2
NAL = $24,000 –  $9,000(1– 0.40)
t=0
(1.06)t
NAL = $366.35
– $24,000 x 0.4 x 0.3 x 1.03 + $1,000 x 0.4 x 0.3 x 1 – $1,000
0.06 + 0.30
1.06
0.06 + 0.30
(1.06) 3 (1.06)3
13. Assuming payments are made at the end of the year:
a.. PV of CCATS = 347.48(.25)(.36) x (1 + .5(.0704))= 94.40
.0704 + .25
1 + .0704
b.
c.
NAL = 0 = -L PVIFA(7.04%,2) – 94.40 + 347.48, therefore, L=140.05.
Before tax payment = 140.05/0.64=$218.83
TLessor=TLessee
Lessee:
NPV =0=347.48 – L ( PVIFA7.04%,2), therefore, L=192.29
L < 192.29, NPV > 0 (Lessee)
L > 192.29, NPV > 0 (Lessor)
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