978-1259709685 Chapter 21 Solution Manual Part 1

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CHAPTER 21

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

2. The less profitable one because leasing provides, among other things, a mechanism for transferring

3. Potential problems include: (1) Care must be taken in interpreting the IRR (a high or low IRR is

4. a. Leasing is a form of secured borrowing. It reduces a firm’s cost of capital only if it is cheaper

b. The statement is not always true. For example, a lease often requires an advance lease payment

c. Leasing would probably not disappear, since it does reduce the uncertainty about salvage value

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

2. The lessee can purchase the asset at a price below its fair market value (bargain purchase

3. The lease term is for 75% or more of the estimated economic life of the asset. The firm

4. The present value of the lease payments is 90% or more of the fair market value of the asset at

6. The lease must meet the following IRS standards for the lease payments to be tax deductible:

1. The lease term must be less than 80% of the economic life of the asset. If the term is longer, the

2. The lease should not contain a bargain purchase option, which the IRS interprets as an equity

3. The lease payment schedule should not provide for very high payments early and very low

4. Renewal options should be reasonable and based on the fair market value of the asset at

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 (those that do not meet the criteria in Question 6)

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

10. Azul Linhas Aereas Brasileiras’ financial position was such that the package of leasing and buying

11. There is the tax motive, but, beyond this, ILFC knows that, in the event of a default, Azul Linhas

12. The plane will be re-leased to Azul Linhas Aereas Brasileiras or another air transportation firm, used

Solutions to Questions and Problems

NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple

steps. Due to space and readability constraints, when these intermediate steps are included in this

solutions manual, rounding may appear to have occurred. However, the final answer for each problem is

found without rounding during any step in the problem.

Basic

1. We will calculate cash flows from the depreciation tax shield first. The depreciation tax shield is:

The aftertax cost of the lease payments will be:

So, the total cash flows from leasing are:

The aftertax cost of debt is:

Using all of this information, we can calculate the NAL as:

The NAL is positive so you should lease.

2. If we assume the lessor has the same cost of debt and the same tax rate, the NAL to the lessor is the

3. To find the maximum lease payment that would satisfy both the lessor and the lessee, we need to

find the payment that makes the NAL equal to zero. Using the NAL equation and solving for the

The OCF for this lease is composed of the depreciation tax shield cash flow, as well as the aftertax

lease payment. Subtracting out the depreciation tax shield cash flow we calculated earlier, we find:

4. If the tax rate is zero, there is no depreciation tax shield foregone. Also, the aftertax lease payment is

the same as the pretax payment, and the aftertax cost of debt is the same as the pretax cost. So:

The NAL to leasing with these assumptions is:

5. We already calculated the breakeven lease payment for the lessor in Problem 3. The assumptions

about the lessor concerning the tax rate have not changed. So, the lessor breaks even with a payment

of $1,747,345.15

For the lessee, we need to calculate the breakeven lease payment which results in a zero NAL. Using

the assumptions in Problem 4, we find:

6. The appropriate depreciation percentages for a 3-year MACRS class asset can be found in Chapter 6.

The depreciation percentages are .3333, .4445, .1481, and .0741. The cash flows from leasing are:

The machine should still be leased. However, notice that the NAL is lower. This is because of the

7. We will calculate cash flows from the depreciation tax shield first. The depreciation tax shield is:

The aftertax cost of the lease payments will be:

So, the total cash flows from leasing are:

The aftertax cost of debt is:

Using all of this information, we can calculate the NAL as:

8. a. Since the lessee has an effective tax rate of zero, there is no depreciation tax shield foregone.

Also, the aftertax lease payment is the same as the pretax payment, and the aftertax cost of debt

b. We will calculate cash flows from the depreciation tax shield first. The depreciation tax shield is:

Using all of this information, we can calculate the minimum lease payment for the lessor as:

c. A lease payment less than $189,010.56 will give the lessor a negative NAL. A payment higher

than $189,934.19 will give the lessee a negative NAL. In either case, no deal will be struck.

Intermediate

9. 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

depreciation tax shield is:

And the aftertax lease payment is:

The aftertax cost of debt is:

Aftertax debt cost = .09(1 – .34)

The equipment should be leased.

To find the maximum payment, we find where the NAL is equal to zero, and solve for the payment.

Using X to represent the maximum payment:

10. The aftertax residual value of the asset is an opportunity cost to the leasing decision, occurring at the

end of the project life (Year 5). Also, the residual 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 aftertax cost of debt to discount the residual value as is common in

practice. Setting the NAL equal to zero:

So, the maximum pretax lease payment is:

11. The security deposit is a cash outflow at the beginning of the lease and a cash inflow at the end of

the lease when it is returned. The NAL with these assumptions is:

With the security deposit, the firm should still lease the equipment since the NAL is greater than

zero. We could also solve this problem another way. From Problem 9, we know that the NAL

So, the NAL with the security deposit is: