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Chapter 19: Lease Financing
1. Many leases written today combine the features of operating and financial leases. Such leases are often called
"combination leases."
a.
True
b.
False
ANSWER:
True
2. A sale and leaseback arrangement is a type of financial, or capital, lease.
a.
True
b.
False
ANSWER:
True
3. Operating leases help to shift the risk of obsolescence from the user to the lessor.
a.
True
b.
False
ANSWER:
True
Chapter 19: Lease Financing
4. Under a sale and leaseback arrangement, the seller of the leased property is the lessee and the buyer is the lessor.
a.
True
b.
False
ANSWER:
True
5. A synthetic lease is a combination of derivative securities and asset purchases that mimic the cash flows of an operating
lease.
a.
True
b.
False
ANSWER:
False
Chapter 19: Lease Financing
6. 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.
a.
True
b.
False
ANSWER:
True
7. 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.
ANSWER:
e
Chapter 19: Lease Financing
8. 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.
ANSWER:
d
9. The full amount of a lease payment is tax deductible provided the contract qualifies as a true lease under IRS
guidelines.
a.
True
b.
False
ANSWER:
True
Chapter 19: Lease Financing
10. 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.
a.
True
b.
False
ANSWER:
True
11. 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.
ANSWER:
b
Chapter 19: Lease Financing
12. 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.
ANSWER:
a
13. 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.
a.
True
b.
False
ANSWER:
False
Chapter 19: Lease Financing
14. 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.
ANSWER:
b
15. 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.
ANSWER:
d
Chapter 19: Lease Financing
16. 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.
ANSWER:
b
17. 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
ANSWER:
c
Chapter 19: Lease Financing
18. 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
ANSWER:
b
Chapter 19: Lease Financing
19. 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
ANSWER:
d
Chapter 19: Lease Financing
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Page 11
20. 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
Chapter 19: Lease Financing
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
ANSWER:
a
Chapter 19: Lease Financing
21. A leveraged lease is more risky from the lessee's standpoint than an unleveraged lease.
a.
True
b.
False
ANSWER:
False
22. 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.
a.
True
b.
False
ANSWER:
False
Chapter 19: Lease Financing
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Page 14
23. 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.
a.
True
b.
False
ANSWER:
False
