3) Assuming that Rearden’s annual lease payments are $1.2 million, then the amount of the
savings in year 0 from leasing is closest to:
A) $3.8 million
B) $3.9 million
C) $4.0 million
D) $4.2 million
4) Assuming that Rearden’s annual lease payments are $1.2 million, then use the direct method,
the NPV of leasing is closest to:
A) ($165,000)
B) ($95,000)
C) $0
D) $95,000
5) Assuming that Rearden’s annual lease payments are $1.2 million, then the effective after-tax
lease borrowing rate is closest to:
A) 7.2%
B) 8.0%
C) 8.8%
D) 9.1%
6) Assuming that Rearden’s annual lease payments are $1.2 million, then Rearden Metal should:
A) lease the furnace since the amount saved in year zero from leasing is greater than the amount
of the lease equivalent loan.
B) buy the furnace since the amount saved in year zero from leasing is greater than the amount of
the lease equivalent loan.
C) lease the furnace since the amount saved in year zero from leasing is less than the amount of
the lease equivalent loan.
D) buy the furnace since the amount saved in year zero from leasing is less than the amount of
the lease equivalent loan.
7) Assuming that Rearden’s annual lease payments are $1.1 million, then the amount of the lease-
equivalent loan is closest to:
A) $3.7 million.
B) $3.8 million.
C) $3.9 million.
D) $4.0 million.
8) Which of the following statements is FALSE?
A) Lease payments are a fixed obligation of the firm.
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 firm’s secured borrowing rate.
C) If a firm 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.
9) 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 financial distress.
C) When a firm enters into a lease, it is committing to lease payments that are a fixed future
obligation of the firm.
D) When a firm leases an asset, it is effectively adding leverage to its capital structure (whether
or not the lease appears on the balance sheet for accounting purposes).
10) Which of the following statements is FALSE?
A) We can compare leasing to buying the asset using equivalent leverage by discounting the
incremental cash flows of leasing versus buying using the after-tax borrowing rate.
B) A non-tax lease is attractive if it offers a better interest rate than would be available with a
loan.
C) Evaluating a true tax lease is much more straightforward than evaluating a non-tax lease.
D) To determine whether a non-tax lease offers a better rate, we discount the lease payments at
the firm’s pre-tax borrowing rate and compare it to the purchase price of the asset.
Use the information for the question(s) below.
St. Martin’s Hospital plans to purchase or lease a $2 million dollar CT scanner. If purchased, the
CT scanner will be depreciated on a straight-line basis over five years, after which it will be
worthless. If leased, the annual lease payments will be $500,000 per year for five years. St.
Martin’s borrowing cost is 8%, and its tax rate is 35%.
11) If St. Martin purchases the CT scanner, what is the amount of the lease-equivalent loan?
12) Is St. Martin’s better off leasing the CT scanner or financing the purchase of the CT scanner
with a lease-equivalent loan and by how much is St Martin’s better off?
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.
13) Assuming that Rearden’s annual lease payments are $1.1 million, then Rearden Metal should
A) lease the furnace since the amount saved in year zero from leasing is greater than the amount
of the lease equivalent loan.
B) buy the furnace since the amount saved in year zero from leasing is greater than the amount of
the lease equivalent loan.
C) lease the furnace since the amount saved in year zero from leasing is less than the amount of
the lease equivalent loan.
D) buy the furnace since the amount saved in year zero from leasing is less than the amount of
the lease equivalent loan.
25.4 Reasons for Leasing
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) The lease rate for which the lessor will break even is closest to:
A) $1,110,000
B) $1,130,000
C) $1,150,000
D) $1,160,000
2) The lease rate for which Rearden will break even is closest to:
A) $1,110,000
B) $1,130,000
C) $1,150,000
D) $1,160,000
3) Which of the following statements is FALSE?
A) For a lease to be attractive to both the lessee and the lessor, the gains must come from some
underlying economic benefits that the leasing arrangement provides.
B) With a true tax lease, the lessor replaces depreciation and interest tax deductions with a
deduction for the lease payments.
C) Generally speaking, if the asset’s tax depreciation deductions are more rapid than its lease
payments, a true tax lease is advantageous if the lessor is in a higher tax bracket than the lessee.
D) A tax gain occurs if the lease shifts the more valuable deductions to the party with the higher
tax rate.
4) Which of the following statements is FALSE?
A) If a firm only needs to use the asset for a short time, it is probably less costly to lease it than
to buy and resell the asset.
B) While owners of assets are likely to resell them only if the assets are “lemons,” a short-term
lease can commit the user of an asset to return it regardless of its quality. In this way leases can
help mitigate the adverse selection problem in the used goods market.
C) Car dealerships are in a better position to sell a used car at the end of a lease than a consumer
is.
D) If the asset’s tax depreciation deductions are faster than its lease payments, there are tax gains
from a true tax lease if the lessor is in a lower tax bracket than the lessee.
5) Which of the following statements is FALSE?
A) By offering assets together with complementary services, lessors can achieve efficiency gains
and offer attractive lease rates.
B) Assets leased under a true lease are afforded bankruptcy protection and cannot be seized in
the event of default.
C) Because of the higher recovery value in the event of default, a lessor may be able to offer
more attractive financing through the lease than an ordinary lender could.
D) Lessors often have efficiency advantages over lessees in maintaining or operating certain
types of assets.
6) Which of the following statements is FALSE?
A) Most financial analysts and sophisticated investors consider operating leases (which must be
listed in the footnotes of the financial statements) to be additional sources of leverage.
B) By carefully avoiding the four criteria that define a operating lease for accounting purposes, a
firm can avoid listing the long-term lease as a liability.
C) Because a lease is equivalent to a loan, the firm can increase its actual leverage without
increasing the debt-to-equity ratio on its balance sheet.
D) For most large corporations, the amount of leverage the firm can obtain through a lease is
unlikely to exceed the amount of leverage the firm can obtain through a loan.
7) Which of the following statements is FALSE?
A) Leasing allows the party best able to bear the risk to hold it. For example, small firms with a
low tolerance for risk may prefer to lease rather than purchase assets.
B) When the lessor is the manufacturer, a lease in which the lessor bears the risk of the residual
value can improve incentives and lower agency costs.
C) For leases in which the lessor retains a substantial interest in the asset’s residual value, the
lessee has more of an incentive to take proper care of an asset that is leased rather than
purchased.
D) Whether they appear on the balance sheet or not, lease commitments are a liability for the
firm.