Chapter 19
Lease Financing
ANSWERS TO END-OF-CHAPTER QUESTIONS
19-1 a. The lessee is the party leasing the property. The party receiving the payments from
the lease (that is, the owner of the property) is the lessor.
b. An operating lease, sometimes called a service lease, provides for both financing and
maintenance. Generally, the operating lease contract is written for a period
considerably shorter than the expected life of the leased equipment, and contains a
cancellation clause. A financial lease does not provide for maintenance service, is not
cancelable, and is fully amortized; that is, the lease covers the entire expected life of
c. Off-balance sheet financing refers to the fact that for many years neither leased assets
nor the liabilities under lease contracts appeared on the lessees’ balance sheets. To
d. FASB Statement 13 is the Financial Accounting Standards Board statement
e. A guideline lease is a lease that meets all of the IRS requirements for a genuine lease.
g. The lessee’s analysis involves determining whether leasing an asset is less costly than
buying the asset. The lessee will compare the present value cost of leasing the asset
with the present value cost of purchasing the asset (assuming the funds to purchase
The lessor’s analysis involves determining the rate of return on the proposed
i. The alternative minimum tax (AMT), which is figured at about 20 percent of the
19-2 An operating lease is usually cancelable and includes maintenance. Operating leases are,
frequently, for a period significantly shorter than the economic life of the asset, so the
19-3 You would expect to find that lessees, in general, are in relatively low income-tax
brackets, while lessors tend to be in high tax brackets. The reason for this is that owning
19-4 The banks, when they initially went into leasing, were paying relatively high tax rates.
However, since municipal bonds are tax-exempt, their heavy investments in municipals
19-5 a. Pros:
The use of the leased premises or equipment is actually an exclusive right, and the
A fixed policy of capitalizing leases among all companies would add to the
b. Cons:
Because the firm does not actually own the leased property, the legal aspect can
be cited as an argument against capitalization.
Some argue that other items should be listed on the balance sheet before leases;
19-6 Lease payments, like depreciation, are deductible for tax purposes. If a 20-year asset
were depreciated over a 20-year life, depreciation charges would be 1/20 per year (more
19-7 In fact, Congress did this in 1981. Depreciable lives were shorter than before; corporate
tax rates were essentially unchanged (they were lowered very slightly on income below
19-8 A cancellation clause would reduce the risk to the lessee since the firm would be allowed
to terminate the lease at any point. Since the lease is less risky than a standard financial
SOLUTIONS TO END-OF-CHAPTER PROBLEMS
19-1 a. (1) Reynolds’ current debt ratio is $400/$800 = 50%.
(2) If the company purchased the equipment its balance sheet would look like:
Current assets $300 Debt (including lease) $600
b. The company’s financial risk (assuming the implied interest rate on the lease is
equivalent to the loan) is no different whether the equipment is leased or purchased.
19-2 Cost of owning:
0 1 2
| | |
Cost (200)
0 1 2
| | |
After-tax lease payment (66) (66)
19-3 a. Balance sheets before lease is capitalized:
Energen
Balance Sheet (Owns new assets)
(Thousands of Dollars)
Hastings Corporation
Balance Sheet (Leases as operating lease)
(Thousands of Dollars)
b. Balance sheet after lease is capitalized:
Hastings Corporation
Balance Sheet (Capitalizes lease)
(Thousands of Dollars)
Current assets $ 25,000 Debt $ 50,000
19-4
I. Cost of Owning:
0 1 2 3 4
After-tax loan paymentsa($135,000) ($135,000) ($135,000) ($1,635,000)
II. Cost of Leasing:
0 1 2 3 4
III. Cost Comparison
Net advantage to leasing (NAL)= PV of leasing – PV of owning
aAfter-tax interest payments = (0.15)($1,500,000)(1-0.40) = $135,000.
bDepreciation tax savings, base on MACRS 3-year life and $1,500,000 cost of new
machinery:.
MACRS Deprec. Tax Savings
Year Allowance Factor Depreciation T (Depreciation)
Since the cost of leasing the machinery is less than the cost of owning it, Big Sky Mining
should lease the equipment.
19-5 a. Borrow and buy analysis:
Cost of Owning: Intermediate Calculation: Depreciation Schedule of New Equipment Purchased
at t = 0.
Year 0 1 2 3 4 5 6
Depreciation rates for
new purchase 33.33% 44.45% 14.81% 7.41%
Cost of Owning: Intermediate Calculation: Amortization Schedule of Loan
Year 0 1 2 3 4 5 6
Loan payment
257,157.
5
257,157.
5
257,157.
5
257,157.
5
257,157.
5
257,157.
5
Cost of Owning: NPV Calculation
After-tax cost of debt = 14% x (1 – T) = 14% x (1 – 0.34) = 9.24%.
Depreciation tax savings = T(Depreciation).
Year 0 1 2 3 4 5 6
Loan payments -257,157.5 -257,157.5 -257,157.5 -257,157.5 -257,157.5 -257,157.5
Interest tax savings 47,600.0 42,023.3 35,665.9 28,418.4 20,156.3 10,737.5
Depreciation Tax
Cost of Leasing: Intermediate Calculation: Depreciation Schedule if Purchase Used Equipment
at End of Lease (Last day of 3rd t=2.99)
The machine will be depreciated according to the MACRS 3-year class schedule.
Year 0 1 2 3 4 5 6
Depreciation Schedule
for purchase at end of
lease 33.33% 44.45% 14.81% 7.41%
Cost of Leasing:
After-tax cost of lease = $320,000 (1 – T) = $320,000(1 – 0.34) = $211,200
Year 0 1 2 3 4 5 6
After-tax lease payment -211,200 -211,200 -211,200
Purchase of machine at end of
Because the NAL is positive, the company should choose the lease.
Note that the maintenance expense is excluded from the analysis since the firm
will have to bear the cost whether it buys or leases the machinery.
Because the firm is keeping the machine for at least 6 years (either because it
b. Using Goal Seek, we find that the purchase price can go up to $343,489 before the
NAL becomes negative.