Finance Chapter 19 Generally The Operating Lease Contract Written For

Chapter 19

Lease Financing

ANSWERS TO BEGINNING-OF–CHAPTER QUESTIONS

19-1 An operating lease is one that typically requires the lessor to service the equipment, that

has a lease term that is much shorter than the life of the equipment, and that can be cancelled

Before 1973, when FASB 13 was passed, firms could lease on a long-term, non-

cancelable basis, and thus create a long–term liability, yet not show either the leased asset

or the liability on its balance sheet. After FASB 13, most financial or capital leases had to

be shown on the balance sheet, with the leased asset appearing as an asset and the PV of

the future lease payments appearing as a liability. This is called “capitalizing the lease,”

and its purpose was to cause balance sheets to better reflect companies’ actual financial

positions. A lease must be capitalized if any one of the following conditions holds:

• The lease terms effectively transfer ownership of the property from the lessor to the

lessee.

Answers and Solutions: 19 – 1

19-2 A synthetic lease involves the creation of a special purpose entity (SPE) that (1) gets a loan,

often for something like 97% of the cost of the asset which is to be leased plus equity from

some source equal to 3% of the cost, (2) then uses those funds to purchase an asset required

by the SPE’s sponsoring corporation, and (3) then the SPE leases the asset to the

The primary purpose of synthetic loans was to get around FASB 13 and allow

companies to keep debt off their balance sheets. Many of them were sham transactions.

The sponsoring corporation really had an obligation to pay off the SPE’s loan, and that

obligation should have been shown on the firm’s balance sheet.

Enron, Tyco, and many other companies used synthetic leases. These companies often

19-3 Lease analysis involves having the lessee find the NAL and the lessor find the NPV. Under

this analysis, the lessee takes the lease payments as tax deductions and the lessor treats

them as income. Moreover, the lessor depreciates the asset for tax purposes. However,

Answers and Solutions: 19 – 2

• The lease term must not exceed 80% of the asset’s expected life. This limits the number

of years of the lease’s life. For example, if the asset has a 10–year life, the maximum

term for the lease is 8 years.

• The leased asset’s residual value at the end of the lease term must be at least 20% of

the asset’s initial value. For example, if the asset had a cost of $100,000, then its

19-4 The tab labeled “Balance Sheet” in the BOC model shows the situation for two companies

that differ only with respect to whether or not they lease. In the debate leading up to FASB

13 in 1973, some argued that investors were mislead by non-capitalized leases. Others

argued that the leasing information, some of which was reported in footnotes to the

financial statements, was sufficient to enable investors to ascertain the effects of leasing.

Those who thought investors were being mislead prevailed, and FASB 13 was passed.

Firms generally choose between (1) leasing and (2) borrowing the money and then

Answers and Solutions: 19 – 3

However, once clever (but devious) accountants figured out how to use synthetic leases

to hide debt, the situation changed. Some companies used synthetic leases to fool lenders

and equity analysts, and as a result the perceived risk was less than it would be had the debt

19-5 NAL stands for Net Advantage to Leasing. It is calculated as follows: (1) Identify the

cash flows associated with leasing the asset and the cash flows associated with borrowing

19-6 BOC model can be used to answer this question. It shows (1) that leasing is a zero sum

game if the key inputs used in the lease analysis (purchase price of asset, maintenance cost,

cost of debt, tax rate, and residual value) are the same for the lessee and lessor. However,

leasing companies often have advantages that are reflected in differences between the

lessee and lessor inputs, and those differences lead to situations where leasing creates

1 Using absolute values results in a positive NAL when leasing is desirable and a negative NAL when leasing is not

desirable. It is easy to get confused, because the cash flows are primarily costs, which are negative. Using absolute

values puts things in a proper context.

Answers and Solutions: 19 – 4

The model is also used to find the minimum lease payment that would be acceptable to

the lessor and the maximum payment that the lessee can afford to pay. The difference

between those two amounts represents a “bargaining range” within which the actual lease

Answers and Solutions: 19 – 5

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 (November

1976) that spells out in detail the conditions under which a lease must be capitalized,

and the specific procedures to follow.

Answers and Solutions: 19 – 6

f. The residual value is the market value of the leased property at the expiration of the

lease. The estimate of the residual value is one of the key elements in lease analysis.

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

h. The net advantage to leasing (NAL) gives the dollar value of the lease to the lessee. It

is, in a sense, the NPV of leasing versus owning.

i. The alternative minimum tax (AMT), which is figured at about 20 percent of the profits

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

Answers and Solutions: 19 – 7

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 tends to

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

payment for the premises is a liability that often must be met. Therefore, leases

should be treated as both assets and liabilities.

Answers and Solutions: 19 – 8

b. Cons:

• Because the firm does not actually own the leased property, the legal aspect can be

cited as an argument against capitalization.

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 if

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

$50,000); and the investment tax credit had been improved a bit by the easing of recapture

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

SOLUTIONS TO END-OF-CHAPTER PROBLEMS

(2) If the company purchased the equipment its balance sheet would look like:

Current assets $300 Debt (including lease) $600

(3) If the company leases the asset and does not capitalize the lease, its debt ratio =

$400/$800 = 50%.

19-2 Cost of owning:

0 1 2

| | |

Cost (200)

Depreciation shield 40 40

(200) 40 40

Answers and Solutions: 19 – 11

19-3 a. Balance sheets before lease is capitalized:

Energen

Balance Sheet (Owns new assets)

(Thousands of Dollars)

Debt/assets ratio = $100/$200 = 50%.

Hastings Corporation

Balance Sheet (Leases as operating lease)

(Thousands of Dollars)

Answers and Solutions: 19 – 12

b. Balance sheet after lease is capitalized:

Hastings Corporation

Balance Sheet (Capitalizes lease)

(Thousands of Dollars)

19-4

I. Cost of Owning:

0

1

2

3

4

After–tax loan paymentsa

($135,000)

($1,635,000)

Depr. tax savingsb

$199,980

$266,700

$88,860

$44,460

($1,440,540)

PV of owning at 9% = −$885,679.47

II. Cost of Leasing:

0

1

2

3

4

Answers and Solutions: 19 – 13