CHAPTER 19—LEASE FINANCING
TRUE/FALSE
1. Many leases written today combine the features of operating and financial leases. Such leases are often
called “combination leases.“
2. A sale and leaseback arrangement is a type of financial, or capital, lease.
3. Operating leases help to shift the risk of obsolescence from the user to the lessor.
4. Under a sale and leaseback arrangement, the seller of the leased property is the lessee and the buyer is
the lessor.
5. The full amount of a lease payment is tax deductible provided the contract qualifies as a true lease
under IRS guidelines.
6. 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.
7. Leasing is typically a financing decision and not a capital budgeting decision. Thus, the availability of
lease financing cannot affect the size of the capital budget.
8. A leveraged lease is more risky from the lessee’s standpoint than an unleveraged lease.
9. A synthetic lease is a combination of derivative securities and asset purchases that mimic the cash
flows of an operating lease.
10. In a synthetic lease a special purpose entity (SPE) is set up by a corporation that wants to acquire the
use of an asset. The SPE borrows up to 97% of its capital, uses its funds to buy the asset, and then
leases it to the sponsoring corporation on a short-term basis. This keeps both the asset and the debt off
the sponsoring company’s books.
11. If a leased asset has a negative residual value, for example, as a result of a statutory requirement to
dispose of an asset in an environmentally sound manner, the lessee of the asset could reasonably
expect to pay a lower lease rate because the asset does not have a positive residual value.
12. 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.
MULTIPLE CHOICE
13. From the lessee viewpoint, the riskiness of the cash flows, with the possible exception of the residual
value, is about the same as the riskiness of the lessee’s
a.
capital budgeting project cash flows.
b.
debt cash flows.
c.
pension fund cash flows.
d.
sales.
e.
equity cash flows.
14. Operating leases often have terms that include
a.
full amortization over the life of the lease.
b.
very high penalties if the lease is canceled.
c.
restrictions on how much the leased property can be used.
d.
much longer lease periods than for most financial leases.
e.
maintenance of the equipment by the lessor.
15. Which of the following statements is most CORRECT?
a.
Capitalizing a lease means that the firm issues equity capital in proportion to its current
capital structure, in an amount sufficient to support the lease payment obligation.
b.
The fixed charges associated with a lease can be as high as, but never greater than, the
fixed payments associated with a loan.
c.
Capital, or financial, leases generally provide for maintenance by the lessor.
d.
A key difference between a capital lease and an operating lease is that with a capital lease,
the lease payments provide the lessor with a return of the funds invested in the asset plus a
return on the invested funds, whereas with an operating lease the lessor depends on the
residual value to realize a full return of and on the investment.
e.
Firms that use “off balance sheet” financing, such as leasing, would show lower debt ratios
if the effects of their leases were reflected in their financial statements.
16. Financial Accounting Standards Board (FASB) Statement #13 requires that for an unqualified audit
report, financial (or capital) leases must be included in the balance sheet by reporting the
a.
residual value as a liability.
b.
present value of future lease payments as an asset and also showing this same amount as
an offsetting liability.
c.
undiscounted sum of future lease payments as an asset and as an offsetting liability.
d.
undiscounted sum of future lease payments, less the residual value, as an asset and as an
offsetting liability.
e.
residual value as a fixed asset.
17. Heavy use of off-balance sheet lease financing will tend to
a.
make a company appear less risky than it actually is because its stated debt ratio will
appear lower.
b.
affect a company’s cash flows but not its degree of risk.
c.
have no effect on either cash flows or risk because the cash flows are already reflected in
the income statement.
d.
affect the lessee’s cash flows but only due to tax effects.
e.
make a company appear more risky than it actually is because its stated debt ratio will be
increased.
18. In the lease versus buy decision, leasing is often preferable
a.
because, generally, no down payment is required, and there are no indirect interest costs.
b.
because lease obligations do not affect the firm’s risk as seen by investors.
c.
because the lessee owns the property at the end of the least term.
d.
because the lessee may have greater flexibility in abandoning the project in which the
leased property is used than if the lessee bought and owned the asset.
e.
because it has no effect on the firm’s ability to borrow to make other investments.
19. A lease versus purchase analysis should compare the cost of leasing to the cost of owning, assuming
that the asset purchased
a.
is financed with long-term debt.
b.
is financed with debt whose maturity matches the term of the lease.
c.
is financed with a mix of debt and equity based on the firm’s target capital structure, i.e., at
the WACC.
d.
is financed with retained earnings.
e.
is financed with short-term debt.
20. Stanley Inc. must purchase $6,000,000 worth of service equipment and is weighing the merits of
leasing the equipment or purchasing. The company has a zero tax rate due to tax loss carry-forwards,
and is considering a 5-year, bank loan to finance the equipment. The loan has an interest rate of 10%
and would be amortized over 5 years, with 5 end-of-year payments. Stanley can also lease the
equipment for 5 end-of-year payments of $1,790,000 each. How much larger or smaller is the bank
loan payment than the lease payment? Note: Subtract the loan payment from the lease payment.
a.
$177,169
b.
$196,854
c.
$207,215
d.
$217,576
e.
$228,455
21. To finance some manufacturing tools it needs for the next 3 years, Waldrop Corporation is considering
a leasing arrangement. 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? (Suggestion: Delete 3 zeros from dollars and
work in thousands.)
a.
$96
b.
$106
c.
$112
d.
$117
e.
$123
22. Delamont Transport Company (DTC) is evaluating the merits of leasing versus purchasing a truck
with a 4-year life that costs $40,000 and falls into the MACRS 3-year class. If the firm borrows and
buys 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%. What is the net advantage to leasing? (Note: Assume MACRS rates for Years 1 to 4
are 0.3333, 0.4445, 0.15, and 0.07.)
a.
$849
b.
$896
c.
$945
d.
$999
e.
$1,047
23. Carmichael Cleaners needs a new steam finishing machine that costs $100,000. The company is
evaluating whether it should lease or purchase the machine. 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? (Note: Assume MACRS
rates for Years 1 to 4 are 0.3333, 0.4445, 0.1481, and 0.0741.)
a.
$5,734
b.
$6,023
c.
$6,324
d.
$6,640
e.
$6,972
