Chapter 21: Leasing

21.1 a. Leasing can reduce uncertainty regarding the resale value of the asset that is
leased.
b. Leasing does not provide 100% financing although it may look as though it does.
Since firms must try to maintain their optimal debt ratio, the use of lease simply
displaces debt. Thus, leasing does not provide 100% financing.
c. Although it is true that leasing displaces debt, empirical studies show that the
companies that do a large amount of leasing also have a high debt-to-equity ratios.
d. If the tax advantages of leasing were eliminated, leasing would probably disappear.
The main reason for the existence of long-term leasing is the differential in the tax
rates paid by the lessee and the lessor.

21.2 a. NPV (lease) = $250,000 - L Α 50.08

= $250,000 - 3.9927 L
= $0
L = $62,614.11
The lease payment is Quartz’a reservation price.

b. Depreciation = $250,000 / 5
= $50,000 per annum
Depreciation tax shield
= $50,000 × 0.35
= $17,500
After-tax discount rate
= 0.08 (1 - 0.35)
= 0.052
NPV (lease) = -$250,000 + L (1 - 0.35) Α 50.052 + $17,500 Α 50.052
= $0
L = $62,405.09
This lease payment is New Leasing Co’s reservation price.

c. If the lease price is greater than Quartz’s reservation price, the lease is a negative
NPV proposal for Quartz. Quartz would rather purchase the equipment than lease
at a payment above its reservation price. Thus, the lessee’s reservation price is the
maximum of the negotiation range.

Answers to End-of-Chapter Problems B-187

21.3 Incremental cash flows from leasing instead of purchasing:

Lease minus Buy Year 0 Year 1 - 5

Lease
Lease payment -$94,200
Tax benefit of lease payment $32,970

Buy (minus)
Cost of machine -(-$350,000)
Lost depreciation tax benefit -$350,000/5 × 0.35
= -$24,500
Total $350,000 -$85,730

NPV = $350,000 - $85,730 Α 50.11(0.65 )

= -$102.66 < $0
The firm should buy the machine.

24.4 Maxwell’s reservation price:

NPV (lease) = $200,000 - L Α 50.10
= $200,000 - 3.7908 L
= $0
L = $52,759.50
Mercer’s reservation price:
Depreciation = $200,000 / 5
= $40,000 per annum
Depreciation tax shield
= $40,000 × 0.35
= $14,000
After-tax discount rate
= 0.10 (1 - 0.35)
= 0.065
NPV (lease) = -$200,000 + L (1 - 0.35) Α 50.065 + $14,000 Α 50.065
= $0
L = $52,502.94
Therefore, the negotiation range is from $52,502.94 to $52,759.50.

21.5 Reservation payment of Raymond:

Value of lease = $100,000 - 0.75 L Α 50.08(0.75 ) = $0
L = $31,652.85
Reservation payment of Liberty: ⎛ 100,000 ⎞
Value of lease = -$100,000+ ⎜ ⎟ × 0.35Α 0.08(0.65 )
5

L = $24,962.04 ⎝ 5 ⎠
Therefore, the negotiation range is from $24,962.04 to $31,652.85. For lease payments
higher than $31,652.85, Raymond will not enter into the arrangement. For lease payments
lower than $24,962.04, Liberty will not enter into the arrangement.

B-188 Answers to End-of-Chapter Problems

21.6 a. The lease payment, which makes both parties equally well off, is the payment,
which equates the NPVs for the firms. Since the tax rates of the two firms are
equal, the perspective of the lessor is the opposite of the perspective of the lessee.
This condition ensures that the NPV is zero.
After-tax cash flows to the lessor
= L (1 - 0.34) + Depreciation (0.34)
Depreciation = $86.87 / 2 = $43.435
The NPV is zero when the NPV of the lessor’s after-tax cash flows equals the cost
of the asset. The appropriate discount rate is the after-tax rate. That rate is 6.6% [=
10% × 0.66].
$86.87 = [0.66 L + $43.435 (0.34)] Α 02.066
$86.87 = [0.66 L + $43.435 (0.34)] (1.8181)
L = $50.02
b. Generalize the result from part a.
Let T1 denote the lessor’s tax rate.
Let T2 denote the lessee’s tax rate.
Let P denote the purchase price of the asset.
Let Dep equal the annual depreciation expense.
Let N denote the length of the lease in years.
N L(1 − T ) + Dep(T )
Value to the lessor = − P + ∑ 1 1
t =1 [1 + r (1 − T1 )] t

N L(1 − T2 ) + Dep(T2 )
Value to the lessee = P − ∑
t =1 [1 + r (1 − T2 )] t

The values of the lease to its two parties will be opposite in sign only if T1 = T2.
c. Since the lessor’s tax bracket is unchanged, the lease has a zero NPV to the lessor
when the lease payment is $50.02.
If the lessee pays no taxes, the pre-tax and after-tax lease payment are the same.
Also, one of the lessee’s cash flows is the depreciation that is foregone when leasing
is chosen over purchasing. If the lessee’s tax rate is zero, it will not benefit from
depreciation. Thus, if the lessee chooses leasing, the lost depreciation is no longer a
cash flow. The lease has a zero NPV to the lessee when L = $50.05.
L Α 02.10 = $86.87
L = $86.87 / 1.7355
= $50.05
If L > $50.05 the NPV to the lessee is < $0.
If L < $50.05 the NPV to the lessee is > $0.
If L > $50.05 the NPV to the lessor is > $0.
If L < $50.05 the NPV to the lessor is < $0.

Both parties have positive NPV for $50.02 < L < $50.05.

21.7 a. Assume that 10% is the market-wide interest rate. The decision to buy or lease is
made by looking at the incremental cash flows.

Answers to End-of-Chapter Problems B-189

 Cash flows from leasing:
Year 0 1 2 3 4 5
A/T savings* $3,960 $3,960 $3,960 $3,960 $3,960
Lease payment -2,100 -2,100 -2,100 -2,100 -2,100
Tax benefit** 714 714 714 714 714
Net cash flows 2,574 2,574 2,574 2,574 2,574
* After tax savings on operations
= $6,000 × 0.66
= $3,960
** Tax benefit
= $2,100 × 0.34
= $714
Cash flows from purchasing:
Year 0 1 2 3 4 5
A/T savings* $5,940 $5,940 $5,940 $5,940 $5,940
Purchase -15,000
Dep tax shield** 1,020 1,020 1,020 1,020 1,020
Net cash flows -15,000 6,960 6,960 6,960 6,960 6,960
* After tax savings on operations
= $9,000 × 0.66
= $5,940
** Depreciation = $15,000 / 5 = $3,000 per annum
Depreciation tax shield
= $3,000 × 0.34
= $1,020
Incremental cash flows from leasing vs. purchasing:
Year 0 1 2 3 4 5
Lease $2,574 $2,574 $2,574 $2,574 $2,574
Purchase -15,000 6,960 6,960 6,960 6,960 6,960
L–P 15,000 -4,386 -4,386 -4,386 -4,386 -4,386

NPV of the incremental cash flows:

The cash flows must be discounted at the after tax rate which is 6.6% [= 10% ×
0.66].
NPV = $15,000 - $4,386 Α 50.066
= $15,000 - $4,386 (4.1445)
= -$3,177.78
Since the NPV of the lease-vs.-buy incremental cash flows is negative, Farmer
should buy, not lease the equipment.
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 of the form of financing.
c. The amount of displaced debt is the PV of the incremental cash flows from year one
through five.
PV = $4,386 (4.1445) = $18,177.78

B-190 Answers to End-of-Chapter Problems

21.8 Redwood:
Year 0 Year 1 - 6 Year 7
Cost of machine $420,000 $0 $0
Lease payment -L -L $0

$420,000 - L = A60.06 L
L = $70,978.03

American:
Year 0 Year 1 - 6 Year 7
Cost of machine -$420,000 $0 $0
Dep tax shield $21,000 $21,000
A/T lease payment 0.65 L 0.65 L $0

Value of lease
= -$420,000 + $21,000 Α 70.06(0.65 ) + 0.65 L + 0.65 L Α 60.06(0.65 )
= -$420,000 + $21,000 (6.0243) + 4.0685 L = $0
L = $72,137
The negotiating range is from $72,137 to $70,978.03.

21.9 The decision to buy or lease is made by looking at the incremental cash flows.
a. Cash flow from leasing:
Year 0 1 2 3
Lease payment -$1,200,000 -$1,200,000 -$1,200,000
Tax benefit* 420,000 420,000 420,000
Net cash flow -$780,000 -$780,000 -$780,000
*Tax benefit = $1,200,000 x .35 = $420,000

Cash flow from purchasing:

Year 0 1 2 3
Purchase cost -$3,000,000
Dep tax shield* $350,000 $350,000 $350,000
Net cash flow -3,000,000 350,000 350,000 350,000
*Depreciation tax shield = [$3,000,000 / 3] x 35% = $350,000

Incremental cash flows from leasing vs. purchasing:

Year 0 1 2 3
Lease -$780,000 -$780,000 -$780,000
Purchase (minus) $3,000,000 -350,000 -350,000 -350,000
Net cash flow $3,000,000 -1,130,000 -1,130,000 -1,130,000

After-tax discount rate

= 0.12 × 0.65
= 0.078
NPV of incremental cash flows
= $3,000,000 - $1,130,000 Α 30.078
= $3,000,000 - $1,130,000 (2.5864)
= $77,339.09

Answers to End-of-Chapter Problems B-191

 Therefore, Wolfson should lease the machine.
b. Wolfson is indifferent at the lease payment which makes the NPV of the incremental
cash flows zero.
NPV = $0
= $3,000,000 - (0.65 L + $350,000) Α 30.078
= $3,000,000 - (0.65 L + $350,000) (2.5864)
L = $1,246,002.96

B-192 Answers to End-of-Chapter Problems