Corporate Finance, 3e (Berk/DeMarzo)
Chapter 25 Leasing
25.1 The Basics of Leasing
1) Which of the following statements is FALSE?
A) A lease is a contract between two parties: the lessee and the lessor.
B) Most leases involve little or no upfront payment.
C) The lessee is the owner of the asset, who is entitled to the lease payments in exchange for
lending the asset.
D) At the end of the contract term, the lease specifies who will retain ownership of the asset and
at what terms.
2) Which of the following statements is FALSE?
A) In a direct lease, the lessor is the manufacturer (or a primary dealer) of the asset.
B) The lease specifies any cancellation provisions, the options for renewal and purchase, and the
obligations for maintenance and related servicing costs.
C) If a firm already owns an asset it would prefer to lease, it can arrange a sale and leaseback
transaction.
D) With many leases, the lessor provides the initial capital necessary to purchase the asset, and
then receives and retains the lease payments.
3) Which of the following statements is FALSE?
A) In a leveraged lease the lessor borrows from a bank or other lender to obtain the initial capital
for the purchase, using the lease payments to pay interest and principal on the loan.
B) In some circumstances, the lessor is not an independent company but rather a separate
business partnership, called a special-purpose entity (SPE), which is created by the lessor for the
sole purpose of obtaining the lease.
C) In a direct lease, the lessor is not the manufacturer, but is often an independent company that
specializes in purchasing assets and leasing them to customers.
D) SPEs are commonly used in synthetic leases, which are designed to obtain specific
accounting and tax treatment.
4) A lease that gives the lessee the option to purchase the asset at its fair market value at the
termination of the lease is called a:
A) fair market value cap lease.
B) fair market value lease.
C) $1.00 out lease.
D) fixed price lease.
5) A lease where ownership of the asset transfers to the lessee at the end of the lease for a
nominal cost is called a:
A) fair market value cap lease.
B) fixed price lease.
C) $1.00 out lease.
D) fair market value lease.
6) A lease where the lessee has the option to purchase the asset at the end of the lease for a set
price that is set upfront in the lease contract is called a:
A) fixed price lease.
B) $1.00 out lease.
C) fair market value lease.
D) fair market value cap lease.
7) A lease where the lessee can purchase the asset at the minimum of its fair market value and a
fixed price is called a:
A) $1.00 out lease.
B) fixed price lease.
C) fair market value lease.
D) fair market value cap lease.
8) Which of the following statements is FALSE?
A) Because we are getting the entire asset when we purchase it with the loan, the loan payments
are higher than the lease payments.
B) In a perfect market, the cost of leasing and then purchasing the asset is equivalent to the cost
of borrowing to purchase the asset.
C) With a lease we are financing the entire cost of the asset, with a standard loan we are
financing only the cost of the economic depreciation of the asset during its life.
D) The amount of the lease payment will depend on the purchase price, the residual value, and
the appropriate discount rate for the cash flows.
9) Which of the following statements is FALSE?
A) Absent market imperfections, leases represent another form of zero-NPV financing available
to a firm, and the Modigliani-Miller propositions apply: Leases neither increase nor decrease
firm value, but serve only to divide the firm’s cash flows and risks in different ways.
B) In a perfect market, the cost of leasing is equivalent to the cost of purchasing and reselling the
asset.
C) Each lease agreement can be tailored to fit the precise nature of the asset and the needs of the
parties at hand.
D) Features of leases will be priced as part of the lease payment. Terms that give valuable
options to the lessee lower the amount of the lease payments, whereas terms that restrict these
options will raise them.
10) Which of the following statements is FALSE?
A) Leases may include early cancellation options that allow the lessee to end the lease early
(perhaps for a fee).
B) The cost of the lease will depend on the asset’s residual value, which is its book value at the
end of the lease.
C) Leases may allow the lessee to trade in and upgrade the equipment to a newer model at
certain points in the lease.
D) Leases may contain buyout options that allow the lessee to purchase the asset before the end
of the lease term.
Use the information for the question(s) below.
Suppose the purchase price of a bulldozer is $90,000, its residual value in four years is certain to
be $15,000, and there is no risk that the lessee will default on the lease. Assume that capital
markets are perfect and the risk-free interest rate is 6% APR with monthly compounding.
11) The monthly lease payments for a four year lease of the Bulldozer are closest to:
A) $1,870
B) $1,825
C) $1,750
D) $2,115
12) Suppose that instead of leasing the bulldozer, the company is considering purchasing a
bulldozer outright by borrowing the purchase price using a four-year annuity loan. The monthly
loan payments for a four year loan to purchase the Bulldozer are closest to:
A) $2,115
B) $1,825
C) $1,870
D) $1,750
13) Calculate the monthly lease payments for a four year $1.00 out lease of the Bulldozer.
14) Calculate the monthly lease payments for a four year fixed price lease that allows the lessee
to buy the Bulldozer at the end of the lease for $8,000.
25.2 Accounting, Tax, and Legal Consequences of Leasing
1) The lease is treated as a capital lease (financial lease) for the lessee and must be listed on the
firm’s balance sheet if it satisfies any of the following conditions EXCEPT:
A) the lease contains an option to purchase the asset at its fair market value.
B) the present value of the minimum lease payments at the start of the lease is 90% or more of
the asset’s fair market value.
C) the title to the property transfers to the lessee at the end of the lease term.
D) the lease term is 75% or more of the estimated economic life of the asset.
2) A lease will be treated as a non-tax lease if it satisfies any of the following conditions
EXCEPT:
A) the property may be acquired the fair market value of the asset at the time when the option
may be exercised.
B) some portion of the lease payments is specifically designated as interest or its equivalent.
C) the lessee receives ownership of the asset on completion of all lease payments.
D) the total amount that the lessee is required to pay for a relatively short period of use
constitutes an inordinately large proportion of the total value of the asset.
3) Which of the following statements regarding operating leases is FALSE?
A) They are also called a finance leases.
B) The lease is viewed as a rental for accounting purposes.
C) The lessee reports the entire lease payment as an operating expense.
D) They are disclosed in the footnotes of the lessee’s financial statements.
4) Which of the following statements regarding capital leases is FALSE?
A) Because capital leases increase the apparent leverage on the firm’s balance sheet, firms
sometimes prefer to have a lease categorized as an operating lease to keep it off the balance
sheet.
B) The firm does not report the present value of the future lease payments as a liability on the
balance sheet.
C) The asset acquired is listed on the lessee’s balance sheet, and the lessee incurs depreciation
expenses for the asset.
D) They are viewed as an acquisition for accounting purposes.
5) Which of the following statements is FALSE?
A) The decision to lease is often driven by real-world market imperfections related to leasing’s
accounting, tax, and legal treatment.
B) When publicly traded firms disclose leasing transactions in their financial statements, they
must follow the recommendations of the Financial Accounting Standards Board (FASB).
C) In its Statement of Financial Accounting Standards No. 13 (FAS13), the FASB provides
specific criteria that distinguish a true tax lease from a non-tax lease.
D) The categories used to report leases on the financial statements affect the values of assets on
the balance sheet, but they have no direct effect on the cash flows that result from a leasing
transaction.
6) Which of the following statements is FALSE?
A) If the lease is deemed to be a true lease, the firm is assumed to have effective ownership of
the asset and the asset is protected against seizure.
B) Although the legal ownership of the asset resides with the lessor, in a non-tax lease the lessee
receives the depreciation deductions.
C) The treatment of leased property in bankruptcy will depend on whether the lease is classified
as a security interest or a true lease by the bankruptcy judge.
D) In a non-tax lease, the interest portion of the lease payment is interest income for the lessor.
7) Which of the following statements regarding leases and bankruptcy is FALSE?
A) Operating and true tax leases are generally viewed as true leases by the courts, whereas
capital and non-tax leases are more likely to be viewed as a security interest.
B) By retaining ownership of the asset, the lessor has the right to repossess it if the lease
payments are not made, even if the firm seeks bankruptcy protection.
C) If a lease contract is characterized as a true lease in bankruptcy, the lessor is in a somewhat
superior position than a lender if the firm defaults.
D) If the lease is classified as a true lease in bankruptcy, then the lessee retains ownership rights
over the asset.
8) Which of the following statements regarding leases and taxes is FALSE?
A) In a non-tax lease, the lessee can deduct the interest portion of the lease payments as an
interest expense.
B) In a true tax lease, the lease payments are treated as revenue for the lessor.
C) In a true tax lease, the lessee receives the depreciation deductions associated with the
ownership of the asset.
D) The IRS separates leases into two broad categories: true tax leases and non-tax leases.
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 fleet of delivery trucks. The price of the fleet is $1.5 million.
9) If Luther acquires the new fleet 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
Assets
Liabilities
Cash
Debt
Property, Plant, and
Equipment
Equity
Total Assets
Total Debt plus Equity
10) If Luther acquires the new fleet 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
11) What will Luther’s balance sheet look like if they acquire the new fleet of delivery trucks
using a capital lease?
12) What will Luther’s balance sheet look like if they acquire the new fleet of delivery trucks
using an operating lease?
25.3 The Leasing Decision
Use the following information to answer the question(s) below.
Rearden Metal is considering the purchase of a new blast furnace costing a total of $5 million
dollars. This furnace will qualify for accelerated depreciation: 20% can be expense immediately,
followed by 32%, 19.2%, 11.52%, 11.52% and 5.76% over the next five years. However,
because of Rearden’s substantial tax loss carry forwards, Rearden estimates its marginal tax rate
to be only 10% over the next five years. Since Rearden will get very little tax benefit from the
depreciation expense, they consider leasing the furnace instead. Suppose that Rearden and the
lessor face the same 8% borrowing rate, but the lessor has a 40% marginal tax rate. Assume that
the furnace is worthless after five years, the lease term is five years, and a lease would qualify as
a true tax lease.
1) Assuming that Rearden’s annual lease payments are $1.1 million, then the effective after-tax
lease borrowing rate is closest to:
A) 8.0%
B) 12.8%
C) 15.4%
D) 17.0%
2) Assuming that Rearden’s annual lease payments are $1.2 million, then the amount of the lease-
equivalent loan is closest to:
A) $3.8 million
B) $3.9 million
C) $4.0 million
D) $4.2 million