978-1260153590 Chapter 27 Solutions Manual

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CHAPTER 27

LEASING

Answers to Concepts Review and Critical Thinking Questions

1. Some key differences are: (a) Lease payments are fully tax-deductible, but only the interest portion

2. The less profitable corporation because leasing provides, among other things, a mechanism for

3. Potential problems include: (a) Care must be taken in interpreting the IRR (a high or low IRR is

4. a. Leasing is a form of secured borrowing. It reduces a firm’s cost of capital only if it is cheaper

b. The statement is not always true. For example, a lease often requires an advance lease payment

c. Leasing would probably not disappear, since it does reduce the uncertainty about salvage value

5. A lease must be disclosed on the balance sheet if one of the following criteria is met:

a. The lease transfers ownership of the asset by the end of the lease. In this case, the firm

b. The lessee can purchase the asset at a price below its fair market value (bargain purchase

c. The lease term is for 75 percent or more of the estimated economic life of the asset. The firm

d. The present value of the lease payments is 90 percent or more of the fair market value of the

6. The lease must meet the following IRS standards for the lease payments to be tax deductible:

a. The lease term must be less than 80% of the economic life of the asset. If the term is longer, the

b. The lease should not contain a bargain purchase option, which the IRS interprets as an equity

c. The lease payment schedule should not provide for very high payments early and very low

d. Renewal options should be reasonable and based on the fair market value of the asset at

7. As the term implies, off-balance sheet financing involves financing arrangements that are not

required to be reported on the firm’s balance sheet. Such activities, if reported at all, appear only in

8. The lessee may not be able to take advantage of the depreciation tax shield and may not be able to

10. China Southern’s financial position was such that leasing probably resulted in the overall best

11. There is the tax motive, but beyond this, ALC knows that, in the event of a default, China Southern

12. The plane will be re-leased to China Southern or another air transportation firm, used by ALC, or it

Solutions to Questions and Problems

NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple

steps. Due to space and readability constraints, when these intermediate steps are included in this

solutions manual, rounding may appear to have occurred. However, the final answer for each problem is

found without rounding during any step in the problem.

Basic

1. We will calculate cash flows from the depreciation tax shield first. The depreciation tax shield is:

The aftertax cost of the lease payments will be:

So, the total cash flows from leasing are:

The aftertax cost of debt is:

Using all of this information, we can calculate the NAL as:

The NAL is positive so you should lease.

2. If we assume the lessor has the same tax rate, the NAL to the lessor is the negative of our company’s

NAL, so:

3. To find the maximum lease payment that would satisfy both the lessor and the lessee, we need to

find the payment that makes the NAL equal to zero. Using the NAL equation and solving for the

OCF, we find:

The OCF for this lease is composed of the depreciation tax shield cash flow, as well as the aftertax

lease payment. Subtracting out the depreciation tax shield cash flow we calculated earlier, we find:

Since this is the aftertax lease payment, we can now calculate the break-even pretax lease payment

as:

4. If the tax rate is zero, there is no depreciation tax shield forgone. Also, the aftertax lease payment is

the same as the pretax payment, and the aftertax cost of debt is the same as the pretax cost. So:

The NAL to leasing with these assumptions is:

5. We already calculated the break-even lease payment for the lessor in Problem 3. The assumption

For the lessee, we need to calculate the break-even lease payment which results in a zero NAL.

Using the assumptions in Problem 4, we find:

So, the range of lease payments that would satisfy both the lessee and the lessor are:

6. The appropriate depreciation percentages for a three-year MACRS class asset can be found in

Chapter 10. The depreciation percentages are .3333, .4445, .1481, and .0741. The cash flows from

leasing are:

Year 1: ($4,800,000)(.3333)(.21) + $1,129,700 = $1,465,666

The machine should still be leased under these assumptions. The NAL is less than in Problem 1

because of the accelerated tax benefits due to depreciation, which represents a cost in the decision to

lease compared to the decision to purchase.

Intermediate

7. The pretax cost savings are irrelevant to the lease versus buy decision, since the firm will definitely

use the equipment and realize the savings regardless of the financing choice made. The depreciation

tax shield is:

And the aftertax lease payment is:

The aftertax cost of debt is:

With these cash flows, the NAL is:

The equipment should be leased.

To find the maximum payment, we find where the NAL is equal to zero, and solve for the payment.

Using X to represent the maximum payment:

So the maximum pretax lease payment is:

So, the maximum pretax lease payment is:

9. The security deposit is a cash outflow at the beginning of the lease and a cash inflow at the end of

the lease when it is returned. The NAL with these assumptions is:

With the security deposit, the firm should still lease the equipment rather than buy it, because the

So, the NAL with the security deposit is:

10. a. The different borrowing rates are irrelevant. A basic tenant of capital budgeting is that the

b. Since both companies have the same tax rate, there is only one lease payment that will result in

The aftertax cost of debt is the lessee’s cost of debt, which is:

Using all of this information, we can calculate the lease payment as:

c. Since the lessor’s tax bracket is unchanged, the zero NAL lease payment is the same as we

11. The APR of the loan is the lease factor times 2,400, so:

To calculate the lease payment we first need the net capitalization cost, which is the base capitalized

cost plus any other costs, minus any down payment or rebates. So, the net capitalized cost is:

The depreciation charge is the net capitalized cost minus the residual value, divided by the term of

the lease, which is:

Next, we can calculate the finance charge, which is the net capitalized cost plus the residual value,

times the lease factor, or:

And the taxes on each monthly payment will be:

The monthly lease payment is the sum of the depreciation charge, the finance charge, and taxes,

which will be:

Challenge

12. With a four-year loan, the annual loan payment will be

The aftertax loan payment is found by:

Aftertax payment = Pretax payment – Interest tax shield

So, we need to find the interest tax shield. To find this, we need a loan amortization table since the

interest payment each year is the beginning balance times the loan interest rate of 8 percent. The

interest tax shield is the interest payment times the tax rate. The amortization table for this loan is:

Year

Beginning

Balance Total Payment

Interest

Payment

Principal

Payment Ending Balance

1 $4,800,000.00 $1,449,219.86 $384,000.00 $1,065,219.86 $3,734,780.14

So, the total cash flows each year are:

Year Beginning Balance

Aftertax

Loan Payment OCF

Total

Cash Flow

1 $1,449,219.86 – $4,800,000(.08)(.21) $1,368,579.86 –$1,381,700 = –$13,120.14

So, the NAL with the loan payments is:

The NAL is the same as if the scanner were purchased with cash because the present value of the