Answers and Solutions: 19 – 1
Chapter 19
Lease Financing
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
of both operating and financial leases. For example, a financial lease that contains a
cancellation clause—normally associated with operating leases—is a combination
lease. A synthetic lease is an arrangement between a company and a special purpose
entity that it creates to borrow money and purchase equipment. Although the “lease”
amounts to actually borrowing money guaranteed by the lessee, it doesn’t appear on
the company’s books as an obligation. A special purpose entity (SPE) is a company
correct this problem, the Financial Accounting Standards Board issued FASB
Statement 13. Capitalizing means incorporating the lease provisions into the balance
sheet by reporting the leased asset under fixed assets and reporting the present value
of future lease payments as debt.
e. A guideline lease is a lease that meets all of the IRS requirements for a genuine lease.
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 asset are obtained through a loan). If the present value cost of the lease is less
than the present value cost of purchasing, the asset should be leased. The lessee can
Time 0 savings is greater than the present value of the incremental costs, there is an
advantage to leasing.
The lessor’s analysis involves determining the rate of return on the proposed
lease. If the rate of return (or IRR) of the lease cash flows exceeds the lessor’s
profits reported to stockholders, is a provision of the tax code that requires profitable
firms to pay at least some taxes if such taxes are greater than the amount due under
standard tax accounting. The AMT has provided a stimulus to leasing for those firms
paying the AMT because leasing lowers profits reported to stockholders.
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
website, in whole or in part.
19-3 You would expect to find that lessees, in general, are in relatively low income-tax
depreciation benefits of owning, so tax rate differentials are less important now than in
19-4 The banks, when they initially went into leasing, were paying relatively high tax rates.
further. Since the lease investments were predicated on obtaining tax shelters, and since
19-5 a. Pros:
The use of the leased premises or equipment is actually an exclusive right, and the
payment for the premises is a liability that often must be met. Therefore, leases
Capitalizing of leases could help management make useful comparisons of
operating results; that is, return on investment data.
website, in whole or in part.
b. Cons:
Because the firm does not actually own the leased property, the legal aspect can
be cited as an argument against capitalization.
Capitalizing leases worsens some key credit ratios; that is, the debt–to-equity ratio
and the debt-to-total capital ratio. This may hamper the future acquisition of
when assets are purchased.
19-6 Lease payments, like depreciation, are deductible for tax purposes. If a 20-year asset
accelerated. The same total taxes would be paid over the 20 years, but because of the
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
able to “sell” their tax shelters through a leasing arrangement, being “paid” in the form of
lower lease charges. A high-bracket lessor could earn a given after-tax return with lower
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
lease, and less risky than straight debt, which cannot usually be prepaid without a
prepayment charge, the discount rate on the cost of leasing might be adjusted to reflect
lower risk. (Note that this requires increasing the discount rate since cash outflows are
being discounted.) The effect on the lessor is just the opposite—risk is increased. (Note
that this would also require an increase in the lessor’s discount rate.)
Answers and Solutions: 19 – 5
SOLUTIONS TO END-OF-CHAPTER PROBLEMS
19-1 a. (1) Reynolds’ current debt ratio is $400/$800 = 50%.
Total assets $1,000 Total claims $1,000
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.
website, in whole or in part.
19-2 Cost of owning:
0 1 2
PV at 6% = -$127.
After-tax lease payment (66) (66)
Reynolds should buy the equipment, because the cost of owning is less than the cost of
leasing.
website, in whole or in part.
19-3 a. Balance sheets before lease is capitalized:
Energen
Balance Sheet (Owns new assets)
(Thousands of Dollars)
Current assets
$ 25,000
Debt
$100,000
Fixed assets
175,000
Equity
100,000
Total assets
$200,000
Total
claims
$200,000
Current assets
$ 25,000
Debt
$ 50,000
Fixed assets
125,000
Equity
100,000
Total assets
$150,000
Total
claims
$150,000
1
2
3
4
Lease payment (AT)
Net cash flow
b. Balance sheet after lease is capitalized:
Hastings Corporation
Balance Sheet (Capitalizes lease)
$ 25,000
Debt
$ 50,000
50,000
PV of lease
payments
50,000
125,000
Equity
100,000
$200,000
Total claims
$200,000
19-4
I. Cost of Owning:
0
1
2
3
4
After-tax loan paymentsa
($135,000)
($135,000)
($135,000)
($1,635,000)
Depr. tax savingsb
$199,980
$266,700
$88,860
$44,460
Residual value
$250,000
Tax on residual
($100,000)
Net cash flow
$0
$4,980
$131,700
($46,140)
($1,440,540)
PV of owning at 9% = −$885,679.47
III. Cost Comparison
Net advantage to leasing (NAL)= PV of leasing – PV of owning
= −$777,532.77 – (−$885,679.47)
MACRS Deprec. Tax Savings
Year Allowance Factor Depreciation T (Depreciation)
1 0.3333 $499,950 $199,980
2 0.4445 666,750 266,700
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%
Depreciation
333,300
444,500
148,100
74,100
Book Value
666,700
222,200
74,100
–
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
Interest
140,000.0
123,598.0
104,899.6
83,583.5
59,283.2
31,580.7
Principal
117,157.5
133,559.5
152,257.9
173,574.0
197,874.3
225,576.8
Ending Loan Balance
1,000,000
882,842.5
749,283.0
597,025.1
423,451.1
225,576.8
0.0
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).