CHAPTER 21
LEASING
Answers to Concepts Review and Critical Thinking Questions
1. Some key differences are: (1) Lease payments are fully tax-deductible, but only the interest portion of
3. Potential problems include: (1) 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
than other forms of secured borrowing. The reduction of uncertainty is not particularly relevant;
5. A lease must be disclosed on the balance sheet if one of the following criteria is met:
2. The lessee can purchase the asset at a price below its fair market value (bargain purchase option)
3. The lease term is for 75% or more of the estimated economic life of the asset. The firm basically
4. The present value of the lease payments is 90% or more of the fair market value of the asset at
the start of the lease. The firm is essentially purchasing the asset on an installment basis.
6. The lease must meet the following IRS standards for the lease payments to be tax deductible:
1. The lease term must be less than 80% of the economic life of the asset. If the term is longer, the
lease is considered to be a conditional sale.
3. The lease payment schedule should not provide for very high payments early and very low
4. Renewal options should be reasonable and based on the fair market value of the asset at renewal
time. This indicates that the lease is for legitimate business purposes, not tax avoidance.
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 the footnotes
8. The lessee may not be able to take advantage of the depreciation tax shield and may not be able to
10. Northern Air Cargo’s financial position was such that the package of leasing and buying probably
11. There is the tax motive, but, beyond this, Cargo Aircraft Management knows that, in the event of a
12. The plane will be re-leased to Northern Air Cargo or another air transportation firm, used by Cargo
Aircraft Management, or it will be sold. There is an active market for used aircraft.
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:
Depreciation tax shield = ($5,200,000/4)(.21)
Depreciation tax shield = $273,000
The aftertax cost of the lease payments will be:
So, the total cash flows from leasing are:
The aftertax cost of debt is:
2. If we assume the lessor has the same cost of debt and the same tax rate, the NAL to the lessor is the
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:
4. If the tax rate is zero, there is no depreciation tax shield foregone. 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:
5. We already calculated the break-even lease payment for the lessor in Problem 3. The assumptions
about the lessor concerning the tax rate have not changed. So, the lessor breaks even with a payment
of $1,567,958.35
6. The appropriate depreciation percentages for a 3-year MACRS class asset can be found in Chapter 6.
The depreciation percentages are .3333, .4445, .1481, and .0741. The cash flows from leasing are:
Year 1: ($5,200,000)(.3333)(.21) + $1,192,900 = $1,556,864
7. We will calculate cash flows from the depreciation tax shield first. The depreciation tax shield is:
Depreciation tax shield = ($545,000/5)(.21)
Depreciation tax shield = $22,890
The aftertax cost of the lease payments will be:
So, the total cash flows from leasing are:
8. a. Since the lessee has an effective tax rate of zero, there is no depreciation tax shield foregone.
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. To find the most the lessee would pay, we set the NAL equal to
zero and solve for the payment. Doing so, we find the most the lessee will pay is:
b. We will calculate cash flows from the depreciation tax shield first. The depreciation tax shield is:
Depreciation tax shield = ($680,000/5)(.23)
Depreciation tax shield = $31,280
c. A lease payment less than $174,357.08 will give the lessor a negative NAL. A payment higher
than $174,822.87 will give the lessee a negative NAL. In either case, no deal will be struck.
9. 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:
Depreciation tax shield lost = ($9,400,000/5)(.23)
Depreciation tax shield lost = $432,400
10. The aftertax residual value of the asset is an opportunity cost to the leasing decision, occurring at the
end of the project life (Year 5). Also, the residual value is not really a debt-like cash flow, since there
is uncertainty associated with it at Year 0. Nevertheless, although a higher discount rate may be
11. 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:
NAL = $9,400,000 – 1,500,000 – 1,578,500 – $1,578,500(PVIFA6.93%,4) – $432,400(PVIFA6.93%,5)
+ $1,500,000/1.06935
12. The decision to lease results in a debt capacity that is lowered by the present value of the aftertax lease
payments. The aftertax lease payment is:
Aftertax lease payment = $325,000(1 – .21)
13. a. Since both companies have the same tax rate, there is only one lease payment that will result in
a zero NAL for each company. We will calculate cash flows from the depreciation tax shield
first. The depreciation tax shield is:
Depreciation tax shield = ($780,000/3)(.22)
Depreciation tax shield = $57,200
b. To generalize the result from part a:
Let T1 denote the lessor’s tax rate.
Let T2 denote the lessee’s tax rate.
The value to the lessor is:
c. Since the lessor’s tax bracket is unchanged, the zero NAL lease payment is the same as we found
in part a. The lessee will not realize the depreciation tax shield, and the aftertax cost of debt will
14. The decision to buy or lease is made by looking at the incremental cash flows. The loan offered by the
bank merely helps you to establish the appropriate discount rate. Since the deal they are offering is
the same as the market-wide rate, you can ignore the offer and use 9 percent as the pretax discount
rate. In any capital budgeting project, you do not consider the financing which was to be applied to a
specific project. The only exception would be if a specific and special financing deal were tied to a
specific project (like a lower-than-market interest rate loan if you buy a particular car).
a. The incremental cash flows from leasing the machine are the lease payments, the tax savings on
the lease, the lost depreciation tax shield, and the saved purchase price of the machine. The lease
payments are due at the beginning of each year, so the incremental cash flows are:
Year 0
Year 1
Year 2
Year 3
Year 4
Lease:
Lease payment
–$710,000
–$710,000
–$710,000
–$710,000
Tax savings on lease
Lost dep. tax shield
Equipment cost
–$683,600
–$683,600
–$683,600
–$144,000
b. The company is indifferent at the lease payment which makes the NAL of the lease equal to zero.
The NAL equation of the lease is:
15. a. The different borrowing rates are irrelevant. A basic tenant of capital budgeting is that the
required return of a project depends on the risk of the project. Since the lease payments are
b. Since both companies have the same tax rate, there is only one lease payment that will result in
a zero NAL for each company. We will calculate cash flows from the depreciation tax shield
first. The depreciation tax shield is:
Depreciation tax shield = ($640,000/3)(.21)
Depreciation tax shield = $44,800
c. Since the lessor’s tax bracket is unchanged, the zero NAL lease payment is the same as we found
in part b. The lessee will not realize the depreciation tax shield, and the aftertax cost of debt will
be the same as the pretax cost of debt. So, the lessee’s maximum lease payment will be:
16. The APR of the loan is the lease factor times 2,400, so:
APR = .00211(2,400)
APR = 5.06%
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:
Net capitalized cost = $38,000 + 550 – 4,000
Net capitalized cost = $34,550
The depreciation charge is the net capitalized cost minus the residual value, divided by the term of the
lease, which is:
17. With a four-year loan, the annual loan payment will be
$5,200,000 = PMT(PVIFA8%,4)
PMT = $1,569,988.18
The aftertax loan payment is found by:
Aftertax payment = Pretax payment – Interest tax shield
18. a. The decision to buy or lease is made by looking at the incremental cash flows, so we need to find
the cash flows for each alternative. The cash flows if the company leases are:
Cash flows from leasing:
Aftertax cost savings = $29,000(1 – .21)
Aftertax cost savings = $22,910
The tax benefit of the lease is the lease payment times the tax rate, so the tax benefit of the lease
is:
And the deprecation tax shield will be:
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Aftertax savings
$25,280
$25,280
$25,280
$25,280
$25,280
Dep. tax shield
Net cash flows
Now we can calculate the incremental cash flows from leasing versus buying by subtracting the
net cash flows from buying from the net cash flows from leasing. The incremental cash flows
from leasing are:
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Lease – Buy
$301,800
–$80,900
–$80,900
–$80,900
–$80,900
–$17,700
The aftertax discount rate is:
b. As long as the company maintains its target debt-equity ratio, the answer does not depend upon
the form of financing used for the direct purchase. A financial lease will displace debt regardless
c. The amount of displaced debt is the PV of the incremental cash flows from Year 1 through Year
5.