CHAPTER 16
LEASING
CHAPTER LEARNING OBJECTIVES
16.1 Identify the basic characteristics of leases and differentiate between
16.2 Describe the accounting treatment of both operating and financial leases.
16.3 Evaluate the lease decision using discounted cash flow valuation methods.
16.4 Explain the various motives for leasing.
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MULTIPLE CHOICE QUESTIONS
1. Asset-based lending is:
a) based on an underlying asset that serves as collateral in the event of default
b) financing that is tied directly to a particular asset
c) a and b
d) none of the above
2. Frank owns a large dump truck. Charles offers to pay Frank $1,500 per month for 36 months’
use of the truck. If Frank accepts the offer, then:
a) Frank is the lessee and Charles is the lessor
b) Frank is the lessor and Charles is the lessee
c) Frank and Charles are lessors
d) Frank and Charles are lessees
3. Under a financial lease:
a) lessee pays the rental payments
b) lessee pays for the insurance
c) lessor maintains the asset
c) all of the above
d) a and b
4. The Quebeclease Company offers La Presse a lease on a large printing press. The current
value of the printing press is $50,000 and it is expected to have a market value of $30,000 in
five years. The annual lease payments are $8,000 per year for five years. At the end of the
lease, La Presse has the right to buy the printing press for $5,000. This is an example of:
I. asset-based financing
II. a lease that is likely to be considered a conditional sales agreement by the CRA
III. a sale and leaseback agreement
a) I only
b) II only
c) I and II only
d) II and III only
5. In an operating lease, the ______ holds title to the asset.
a) lessee
b) lessor
c) supplier
d) a or b
6. The lease that is most like a rental agreement is:
a) the capital lease
b) the financial lease
c) the equipment lease
d) the operating lease
7. Air Canada sold an airplane and used the proceeds to improve its financial position. It then
leased the airplane back in order to continue the use of the asset. This is an example of:
a) a leveraged lease
b) a short-term lease
c) a sale and leaseback
d) an operating lease
e) none of the above
8. Use the following statements to answer this question:
I. Leverage leasing does not provide the same benefits to the lessor in Canada as it does in the
U.S.
II. Amortizing the asset on the lessor’s balance sheet is a major benefit for financial lease
revenue.
a) I and II are correct.
b) I and II are incorrect.
c) I is correct and II is incorrect.
d) I is incorrect and II is correct.
9. The Canada Revenue Agency‘s definition of financial lease allows:
a) the lessor to benefit from high CCA
b) the lessor to own the asset
c) the lessee to expense payments to the lessor
d) the lessee to own the asset
16 – 5 Test Bank for Introduction to Corporate Finance, Fourth Canadian Edition
10. Before 1989, what was the benefit of the sale and leaseback agreement?
a) A loophole in the tax laws
b) An illegal transfer of costs between lessee and lessor
c) A mutual benefit between companies in different countries
d) More important in the 1990s
11. Which of the following is/are true about operating leases?
I. The lessee can usually cancel the lease on relatively short notice.
II. The lessee provides maintenance for the asset.
III. The lessee assumes any risk of obsolescence.
a) I only
b) II and III
c) I and III
d) I and II
12. Which of the following is false about a sale and leaseback arrangement?
a) The lessee obtains the use of an asset not previously owned.
b) The lessee sells an asset to a financial institution, which then leases the asset back to the
lessee.
c) The lessor purchases the equipment.
d) The lessor is permitted to deduct CCA on the leased assets for income tax purposes.
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13. Which of the following are characteristics of financial or capital leases?
I. The lease term is equal to 75 percent or more of the economic life of the leased property.
II. The present value of the minimum lease payments is equal to 70 percent or more of the fair
value of the leased property at the inception of the lease.
III. Provisions are made such that ownership of the leased property is transferred to the lessee
at the end of the lease term.
a) I and II
b) II and III
c) I and III
d) I, II and III
14. Use the following statement to answer this question:
Under a leveraged lease, the lessee borrows money that is then used to make the lease
payments.
a) True
b) False
c) Need additional information
15. The residual value is a ______ cash flow, from the point of view of the lessee.
a) positive
16 – 7 Test Bank for Introduction to Corporate Finance, Fourth Canadian Edition
b) negative
c) non-existent (since the lessee does not own the asset)
d) positive or negative, depending on the tax rate
16. All of the following must be included on a company’s balance sheet except:
a) capital leases
b) sale and leaseback agreements
c) operating leases
d) leveraged leases
17. Leasing, and its respective effects on the firm, is very similar to ______ financing.
a) equity
b) debt
c) guaranteed
d) trade
18. Use the following statements to answer this question:
I. An increase in the interest rate of the lease would decrease the PV of rental revenue for an
operating lease.
II. An increase in interest rates would decrease the value of assets from the financial lease on
the lessor’s balance sheet.
a) I and II are correct.
b) I and II are incorrect.
c) I is correct and II is incorrect.
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d) I is incorrect and II is correct.
19. An operating lease compared to a financial lease will result in:
a) higher net income in the early years and no difference in net income in the later years.
b) higher net income in the early years and lower net income in the later years.
c) lower net income in the early years and higher net income in the later years.
d) no difference as the classification of the lease has no effect on net income.
20. Compared with an operating lease, a financial lease will have:
a) lower cash flow from operations (CFO) and higher cash flow from financing (CFF)
b) higher CFO and lower CFF
c) higher CFO and higher CFF
d) the same CFO and CFF
21. Compared with a financial lease, an operating lease will be associated with:
a) higher earnings per share
b) lower earnings per share
c) no difference in earnings per share
d) impact on earnings per share cannot be determined as operating leases are off-balance
sheet items
22. Canada Lease Co. is considering switching from using operating leases to financial leases.
The expected impact on its stock price is:
a) the price should fall as the earnings per share will decline.
b) the price should not change as the ROA does not change.
c) the price should not change as the total cash flows will not change.
d) the price should rise as the cash flow from operations will rise.
23. Use the following statement to answer this question:
Capital leases are evaluated by discounting the lease payments at the company’s WACC
a) True
b) False
c) Need additional information
24. Use the following statement to answer this question:
Capital leases are evaluated by discounting the salvage value at the company’s WACC
a) True if the salvage value is more risky
b) False
25. RonCo Company is considering a recycling project. The project will result in a significant
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decrease in their garbage disposal costs. The acquisition cost of the recycling machine is
$100,000. The present value of the depreciation tax shield (CCA) is $35,000 and the machine is
expected to have a zero salvage value. The firm can lease the machine instead of buying it –
the present value of the before-tax lease payments is $60,000 and the present value of the tax
savings from the lease payments is $20,000. Should the firm lease the recycling machine and
why or why not?
a) Yes, the NPV of leasing is $60,000.
b) Yes, the NPV of leasing is $25,000.
c) No, the NPV of leasing is −$40,000.
d) No, the NPV of leasing is −$175,000.
26. You are the CFO of a company. You are considering leasing photocopiers from the
manufacturer instead of purchasing them for $200,000. You can borrow at 9 percent and the
corporate tax rate is 35 percent. The lease payment will be $50,000 each year for 5 years,
beginning immediately. At the end of the 5 years, the photocopiers will be worthless. Assume
that the photocopiers can be depreciated by $40,000 per year for 5 years, for tax purposes.
Should the firm lease the photocopiers?
a) Yes, the IRR of the lease incremental cash flows is greater than the after-tax cost of
borrowing.
b) No, the IRR of the lease incremental cash flows is less than the after-tax cost of borrowing.
c) Yes, the IRR of the lease incremental cash flows is less than the after-tax cost of borrowing.
d) No, the IRR of the lease incremental cash flows is greater than the after-tax cost of
borrowing.
27. You are the CFO of a company. You are considering leasing photocopiers from the
manufacturer instead of purchasing them for $200,000. You can borrow at 9 percent and the
corporate tax rate is 35 percent. The lease payment will be $50,000 for 5 years, beginning
today. At the end of the 5 years, the photocopiers will be worthless. Assume that the
photocopiers can be depreciated $40,000 per year for tax purposes. What is the IRR of the
lease incremental cash flows?
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a) 5.85%
b) 7.00%
c) 9.00%
d) 12.03%
28. A firm is considering leasing a new machine. The firm can borrow at 12%, and the cost of
capital is 14%. What is the approximate discount rate for valuing the lease if the corporate tax
rate is 40%?
a) 12%
b) 14%
c) 2.7%
d) 7.2%
29. When deciding whether or not to lease an asset, the ______ should be compared against
the ______, and if the first is lower, then the company should proceed with the lease.
a) internal rate of return / after-tax cost of debt
b) wacc / after-tax cost of debt
c) after-tax cost of debt / internal rate of return
d) return on equity / wacc
30. MontRec Company is considering a recycling project. The project will result in a decrease in
their garbage disposal costs. The acquisition cost of the recycling machine is $100,000 and the
present value of the net garbage disposal cost savings is calculated to be $25,000. The present
value of the depreciation tax shield (CCA) is $35,000 and the machine is expected to have a