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.
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.
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
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.
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
419
NAL6% = $67.99
Intermediate
2.
Assuming end of year lease payments:
I=$2,500,000, SV4=0, L=$800,000/yr., d = 30%, T = 37%, and r = 7.5%
The after-tax cost of debt is 7.5(1–.37) = 4.725%
PV of CCATS = 2,500,000(.3)(.37) x (1 + .5(.04725)) = $781,108.29
.04725 + .30
1 + .04725
NAL = 2,500,000 – 800,000(1–.37) x PVIFA (4.725%, 4) – 781,108.29 = -$79,743.04
Therefore, the firm should buy the equipment.
3.
A loss for the lessee means a gain for the lessor = $79,743.04
4.
NAL = 0 = $2,500,000 – X(PVIFA4.725%,4) – 781,108.29; X = $481,655.00 is the after-tax lease payment.
Before tax lease payment = $481,655.00/0.63 = $764,531.75
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 = .075 annual cost of leasing = leasing payment = $800,000
NAL = $2,500,000 – $800,000(PVIFA7.5%,4) = -$179,461.02
6.
The lessor breaks even with a payment of $764,531.75 (from problem 4).
Lessee: breakeven payment — NAL = 0 = $2,500,000 – PMT(PVIFA7.5%,4) ; PMT = $746,418.77
Total payment range = $746,418.77 to $764,531.75
Scanner cost=$2,500,000, SV4=0, Lease payment=$800,000/yr., d=50%, T=37%, and r=7.5%
7.
The after-tax cost of debt is 7.5(1–.37) = 4.725%
PV of CCATS = 2,500,000(.5)(.37) x (1 + .5(.04725)) = 826,069.30
.04725 + .5
1 + .04725
NAL = 2,500,000 – 800,000(1– .37) x PVIFA 4.725%, 4) – 826,069.30 = -$124,704.05
With the larger CCA tax shield the firm has a greater incentive to buy than before. Therefore, the firm
should not lease the equipment.
8.
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. We will also
assume beginning of year payments.
After-tax cost of debt = .085(1 – .36) = .0544
PV of CCATS = 6,000,000(.25)(.36) x (1 + .5(.0544)) – 650,000(.25)(.36) x
1
.0544 + .25
1 + .0544
.0544 + .25
(1 + .0544) 5
= 1,580,755.40
After-tax lease payment = $1,350,000(1 – .36) = $864,000
NAL = $6M – $864,000(1.0544)(PVIFA5.44%, 5) – 1,580,755.40 – 650,000 (PVIF5.44%, 5) = $23,845.54
The equipment should be leased.
420
Maximum payment:
NAL = 0 = $6M – $X(1.0544)(PVIFA5.44%, 5) – 1,580,755.40 – 650,000 (PVIF5.44%, 5)
X = $869,287.25
pretax lease payment = $869,287.25/(1 – .36) = $1,358,261.33
9.
PV of CCATS = 6,000,000(.25)(.36) x (1 + .5(.0544)) = 1,728,218.80
.0544 + .25
1 + .0544
NAL = 0 = $6M – $X(1.0544)(PVIFA5.44%, 5) – 1,728,218.80
X = $947,178.63
pretax lease payment = $947,178.63/(1 – .36) = $1,479,966.61
10.
The security deposit of $400,000 reduces the initial benefit of leasing (not having to pay $6M 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 = $5.6M – $864,000(1.0544)(PVIFA5.44%, 5) – 1,580,755.40 – 250,000 (PVIF5.44%, 5) = -$69,228.94
With the security deposit, the firm should buy the equipment since the NAL is less than zero.
Challenge
11.
loan amount = $2,500,000 = PMT(PVIFA7.5%,4) ; PMT = $746,418.77
PV after-tax payment = PV(payment – interest tax shield):
year 1: PV($746,418.77 – ($2,500,000.00)(.075)(.37)) = $677,043.77/1.04725
year 2: PV($746,418.77 – ($1,941,081.23)(.075)(.37)) = $692,553.77/1.04725 2
year 3: PV($746,418.77 – ($1,340,243.55)(.075)(.37)) = $709,227.01/1.04725 3
year 4: PV($746,418.77 – ($694,343.04)(.075)(.37)) = $727,150.75/1.04725 4
Where the interest tax shield is calculated on the balance remaining on the loan (i.e., the present value of
the remaining loan payments) for each year.
NAL = 2,500,000 – 800,000(1 – .37) x PVIFA (4.725%, 4) – 781,108.29 = -$79,743.04
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 $2,500,000.
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 = $422.32
– $24,000 x 0.4 x 0.3 x 1.03 + $900 x 0.4 x 0.3 x 1 – $900
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 = 367.48(.25)(.35) x (1 + .5(.065)) = 98.96
.065 + .25
1 + .065
b.
c.
NAL = 0 = -L PVIFA(6.5%,2) – 98.96 + 367.48, therefore, L=$147.49.
Before tax payment = $147.49/0.65=$226.90
TLessor=TLessee
Lessee:
NPV =0=367.48 – L ( PVIFA6.5%,2), therefore, L=$201.84
L < $201.84, NPV > 0 (Lessee)
L > $201.84, NPV > 0 (Lessor)
421
422