Use the table for the question(s) below.
Luther Industries currently has the following balance sheet (in Thousands of dollars):
Assets Liabilities
Cash $500 Debt $4,500
Property, Plant, and
Equipment $7,000 Equity $3,000
Total Assets $7,500
Total Debt plus
Equity $7,500
Luther is about to add a new leet of delivery trucks. The price of the leet is $1.5 million.
9) If Luther acquires the new leet of delivery trucks using a capital lease, Luther’s debt-to-
equity ratio will be closest to ________.
A) 0.66
B) 1.5
C) 0.80
D) 2.0
AACSB Objective: Analytic Skills
Author: JN
Question Status: Previous Edition
11
10) Suppose the lease is a ive-year fair market value lease, and the trucks have a
remaining useful life of 8 years. If the monthly lease payments are $25,000 and the
appropriate discount rate is 6% APR with monthly compounding, will the lease be classiied
as an operating lease or a capital lease for the lessee?
A) Capital lease, because the title to the property transfers to the lessee at the end of the
lease term.
B) Capital lease, because the present value of the minimum lease payments at the start of
the lease is 90% or more of the asset’s fair value.
C) Operating lease, because the present value of the minimum lease payments at the start
of the lease is less than 90% of the asset’s fair value.
D) Operating lease, because the lease term is more than 75% of the estimated economic
life of the asset.
AACSB Objective: Analytic Skills
Author: JP
Question Status: Previous Edition
11) If Luther acquires the new leet of delivery trucks using an operating lease, Luther’s
debt-to-equity ratio will be closest to ________.
A) 2.0
B) 1.5
C) 0.80
D) 0.66
AACSB Objective: Analytic Skills
Author: JN
Question Status: Previous Edition
12
12) What will Luther’s balance sheet look like if they acquire the new leet of delivery
trucks using a capital lease?
AACSB Objective: Analytic Skills
Author: JN
Question Status: Previous Edition
13) What will Luther’s balance sheet look like if they acquire the new leet of delivery
trucks using an operating lease?
AACSB Objective: Analytic Skills
Author: JN
Question Status: Previous Edition
13
24.3 The Leasing Decision
1) Which of the following statements is FALSE?
A) Lease payments are a ixed obligation of the irm.
B) The risk of the lease payments is no greater than the risk of secured debt, so it is
reasonable to discount the lease payments at the irm’s secured borrowing rate.
C) If a irm purchases a piece of equipment, the expense is a capital expenditure.
Therefore, the purchase price can be depreciated over time, generating a depreciation tax
shield.
D) If the equipment is leased and the lease is a non-tax lease, there is no capital
expenditure, but the lease payments are an operating expense.
AACSB Objective: Analytic Skills
Author: JN
Question Status: Previous Edition
2) Which of the following statements is FALSE?
A) The lease-equivalent loan is the loan that is required on the purchase of the asset that
leaves the purchaser with the same obligations as the lessor would have.
B) Lease obligations themselves could trigger inancial distress.
C) When a irm enters into a lease, it is committing to lease payments that are a ixed
future obligation of the irm.
D) When a irm leases an asset, it is efectively adding leverage to its capital structure
(whether or not the lease appears on the balance sheet for accounting purposes).
AACSB Objective: Analytic Skills
Author: JN
Question Status: Previous Edition
14
3) Which of the following statements is FALSE?
A) We can compare leasing to buying the asset using equivalent leverage by discounting
the incremental cash lows of leasing versus buying using the after-tax borrowing rate.
B) A nontax lease is attractive if it ofers a better interest rate than would be available with
a loan.
C) Evaluating a true tax lease is much more straightforward than evaluating a nontax lease.
D) To determine whether a nontax lease ofers a better rate, we discount the lease
payments at the irm’s pretax borrowing rate and compare it to the purchase price of the
asset.
AACSB Objective: Analytic Skills
Author: JN
Question Status: Previous Edition
4) Which of the following discount rates should be used for the lease versus borrow
decision?
A) the risk-free rate of interest
B) the company’s cost of borrowing
C) the company’s after-tax cost of borrowing
D) the company’s weighted average cost of capital
AACSB Objective: Analytic Skills
Author: JP
Question Status: Previous Edition
5) Which of the following is considered an unfair comparison?
A) FMV lease versus $1.00-out lease
B) $1.00-out lease versus true tax lease
C) lease versus buy
D) lease versus borrow
AACSB Objective: Analytic Skills
Author: JP
Question Status: Previous Edition
15
Use the information for the question(s) below.
St. Martin’s Hospital plans to purchase or lease a $2 million CT scanner. If purchased, the
CT scanner will be depreciated on a straight-line basis over ive years, after which it will be
worthless. If leased, the annual lease payments will be $500,000 per year for ive years. St.
Martin’s borrowing cost is 8%, and its tax rate is 35%.
6) What is the amount of the lease-equivalent loan for the CT Scanner?
A) $74,890.28
B) $1,749,890.28
C) $3,487,027.19
D) $2,367,559.51
AACSB Objective: Analytic Skills
Author: JP
Question Status: Previous Edition
16