CHAPTER 18

LEASE FINANCING

Please see the preface for information on the AACSB letter indicators (F, M,
etc.) on the subject lines.

True/False

Easy:
(18.1) Types of leases FI Answer: a EASY
1. Many leases written today combine the features of operating and financial
leases. Such leases are often called “combination leases.”

a. True
b. False

(18.1) Types of leases FI Answer: a EASY

2. A sale and leaseback arrangement is a type of financial, or capital,
lease.

a. True
b. False

(18.1) Operating lease FI Answer: a EASY

3. Operating leases help to shift the risk of obsolescence from the user to
the lessor.

a. True
b. False

(18.1) Sale and leaseback FI Answer: a EASY

4. Under a sale and leaseback arrangement, the seller of the leased property
is the lessee and the buyer is the lessor.

a. True
b. False

(18.2) Lease payments FI Answer: a EASY

5. The full amount of a lease payment is tax deductible provided the
contract qualifies as a true lease under IRS guidelines.

a. True
b. False

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Chapter 18: Leasing True/False Page 1
 (18.3) Off-balance sheet leasing FI Answer: a EASY
6. Leasing is often referred to as off-balance sheet financing because lease
payments are shown as operating expenses on a firm's income statement
and, under certain conditions, leased assets and associated liabilities
do not appear on the firm's balance sheet.

a. True
b. False

(18.4) Lease financing FI Answer: b EASY

7. Leasing is typically a financing decision and not a capital budgeting
decision. Thus, the availability of lease financing cannot affect the
size of the capital budget.

a. True
b. False

(18.5) Leveraged lease FI Answer: b EASY

8. A leveraged lease is more risky from the lessee’s standpoint than an
unleveraged lease.

a. True
b. False

Medium:
(18.1) Synthetic leases FI Answer: b MEDIUM
9. A synthetic lease is a combination of derivative securities and asset
purchases that mimic the cash flows of an operating lease.

a. True
b. False

(18.1) Synthetic leases FI Answer: a MEDIUM

10. In a synthetic lease a special purpose entity (SPE) is set up by a
corporation that wants to acquire the use of an asset. The SPE borrows
up to 97% of its capital, uses its funds to buy the asset, and then
leases it to the sponsoring corporation on a short-term basis. This
keeps both the asset and the debt off the sponsoring company’s books.

a. True
b. False

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Page 2 True/False Chapter 18: Leasing

 (18.6) Residual value and lease rates FI Answer: b MEDIUM
11. If a leased asset has a negative residual value, for example, as a result
of a statutory requirement to dispose of an asset in an environmentally
sound manner, the lessee of the asset could reasonably expect to pay a
lower lease rate because the asset does not have a positive residual
value.

a. True
b. False

(18.6) Residual value and lease rates FI Answer: b MEDIUM

12. Assume that a piece of leased equipment has a relatively high rather than
low expected residual value. From the lessee's viewpoint, it might be
better to own the asset rather than lease it because with a high residual
value the lessee will likely face a higher lease rate.

a. True
b. False

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Chapter 18: Leasing True/False Page 3
Multiple Choice: Conceptual

Easy:
(18.4) Lease cash flows CI Answer: c EASY
13. From the lessee viewpoint, the riskiness of the cash flows, with the
possible exception of the residual value, is about the same as the
riskiness of the lessee's

a. equity cash flows.

b. capital budgeting project cash flows.
c. debt cash flows.
d. pension fund cash flows.
e. sales.

Medium:
(18.1) Operating lease CI Answer: a MEDIUM
14. Operating leases often have terms that include

a. maintenance of the equipment by the lessor.

b. full amortization over the life of the lease.
c. very high penalties if the lease is cancelled.
d. restrictions on how much the leased property can be used.
e. much longer lease periods than for most financial leases.

(18.1) Leasing CI Answer: e MEDIUM

15. Which of the following statements is most CORRECT?

a. Firms that use "off balance sheet" financing, such as leasing, would
show lower debt ratios if the effects of their leases were reflected
in their financial statements.
b. Capitalizing a lease means that the firm issues equity capital in
proportion to its current capital structure, in an amount sufficient
to support the lease payment obligation.
c. The fixed charges associated with a lease can be as high as, but never
greater than, the fixed payments associated with a loan.
d. Capital, or financial, leases generally provide for maintenance by the
lessor.
e. A key difference between a capital lease and an operating lease is
that with a capital lease, the lease payments provide the lessor
with a return of the funds invested in the asset plus a return on
the invested funds, whereas with an operating lease the lessor
depends on the residual value to realize a full return of and on the
investment.

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Page 4 Conceptual Questions Chapter 18: Leasing

 (18.3) Capitalizing leases CI Answer: c MEDIUM
16. Financial Accounting Standards Board (FASB) Statement #13 requires that
for an unqualified audit report, financial (or capital) leases must be
included in the balance sheet by reporting the

a. residual value as a fixed asset.

b. residual value as a liability.
c. present value of future lease payments as an asset and also showing
this same amount as an offsetting liability.
d. undiscounted sum of future lease payments as an asset and as an
offsetting liability.
e. undiscounted sum of future lease payments, less the residual value, as
an asset and as an offsetting liability.

(18.3) Off-balance sheet leasing CI Answer: b MEDIUM

17. Heavy use of off-balance sheet lease financing will tend to

a. make a company appear more risky than it actually is because its

stated debt ratio will be increased.
b. make a company appear less risky than it actually is because its
stated debt ratio will appear lower.
c. affect a company's cash flows but not its degree of risk.
d. have no effect on either cash flows or risk because the cash flows are
already reflected in the income statement.
e. affect the lessee’s cash flows but only due to tax effects.

(18.4) Lease decision CI Answer: e MEDIUM

18. In the lease versus buy decision, leasing is often preferable

a. because it has no effect on the firm's ability to borrow to make other

investments.
b. because, generally, no down payment is required, and there are no
indirect interest costs.
c. because lease obligations do not affect the firm’s risk as seen by
investors.
d. because the lessee owns the property at the end of the least term.
e. because the lessee may have greater flexibility in abandoning the
project in which the leased property is used than if the lessee bought
and owned the asset.

(18.4) Lease analysis discount rate CI Answer: c MEDIUM

19. A lease versus purchase analysis should compare the cost of leasing to
the cost of owning, assuming that the asset purchased

a. is financed with short-term debt.

b. is financed with long-term debt.
c. is financed with debt whose maturity matches the term of the lease.
d. is financed with a mix of debt and equity based on the firm’s target
capital structure, i.e., at the WACC.
e. is financed with retained earnings.

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to a publicly accessible website, in whole or in part.

Chapter 18: Leasing Conceptual Questions Page 5

Multiple Choice: Problems

Easy:
(18.4) Difference in payments CI Answer: c EASY
20. Sutton Corporation, which has a zero tax rate due to tax loss carry-
forwards, is considering a 5-year, $6,000,000 bank loan to finance
service equipment. The loan has an interest rate of 10% and would be
amortized over 5 years, with 5 end-of-year payments. Sutton can also
lease the equipment for 5 end-of-year payments of $1,790,000 each. How
much larger or smaller is the bank loan payment than the lease payment?
Note: Subtract the loan payment from the lease payment.

a. $177,169
b. $196,854
c. $207,215
d. $217,576
e. $228,455

Medium:
(18.4) Net advantage to leasing (NAL) CI Answer: b MEDIUM
21. Kohers Inc. is considering a leasing arrangement to finance some
manufacturing tools that it needs for the next 3 years. The tools will
be obsolete and worthless after 3 years. The firm will depreciate the
cost of the tools on a straight-line basis over their 3-year life. It
can borrow $4,800,000, the purchase price, at 10% and buy the tools, or
it can make 3 equal end-of-year lease payments of $2,100,000 each and
lease them. The loan obtained from the bank is a 3-year simple
interest loan, with interest paid at the end of the year. The firm's
tax rate is 40%. Annual maintenance costs associated with ownership
are estimated at $240,000, but this cost would be borne by the lessor
if it leases. What is the net advantage to leasing (NAL), in
thousands? (Suggestion: Delete 3 zeros from dollars and work in
thousands.)

a. $96
b. $106
c. $112
d. $117
e. $123

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to a publicly accessible website, in whole or in part.

Page 6 Problems Chapter 18: Leasing

Hard:
(18.4) Lessee's analysis CI Answer: d HARD
22. Dakota Trucking Company (DTC) is evaluating a potential lease for a
truck with a 4-year life that costs $40,000 and falls into the MACRS 3-
year class. If the firm borrows and buys the truck, the loan rate
would be 10%, and the loan would be amortized over the truck’s 4-year
life, so the interest expense for taxes would decline over time. The
loan payments would be made at the end of each year. The truck will be
used for 4 years, at the end of which time it will be sold at an
estimated residual value of $10,000. If DTC buys the truck, it would
purchase a maintenance contract that costs $1,000 per year, payable at
the end of each year. The lease terms, which include maintenance, call
for a $10,000 lease payment (4 payments total) at the beginning of each
year. DTC's tax rate is 40%. Should the firm lease or buy? (Note:
MACRS rates for Years 1 to 4 are 0.33, 0.45, 0.15, and 0.07.)

a. $849
b. $896
c. $945
d. $997
e. $1,047

(18.4) Lessee's analysis CI Answer: a HARD

23. Buster’s Beverages is negotiating a lease on a new piece of equipment
that would cost $100,000 if purchased. The equipment falls into the
MACRS 3-year class, and it would be used for 3 years and then sold,
because the firm plans to move to a new facility at that time. The
estimated value of the equipment after 3 years is $30,000. A
maintenance contract on the equipment would cost $3,000 per year,
payable at the beginning of each year. Alternatively, the firm could
lease the equipment for 3 years for a lease payment of $29,000 per
year, payable at the beginning of each year. The lease would include
maintenance. The firm is in the 20% tax bracket, and it could obtain a
3-year simple interest loan, interest payable at the end of the year,
to purchase the equipment at a before-tax cost of 10%. If there is a
positive Net Advantage to Leasing the firm will lease the equipment.
Otherwise, it will buy it. What is the NAL?

a. $5,736
b. $6,023
c. $6,324
d. $6,640
e. $6,972

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to a publicly accessible website, in whole or in part.

Chapter 18: Leasing Problems Page 7

 CHAPTER 18
ANSWERS AND SOLUTIONS
1. (18.1) Types of leases FI Answer: a EASY

2. (18.1) Types of leases FI Answer: a EASY

3. (18.1) Operating lease FI Answer: a EASY

4. (18.1) Sale and leaseback FI Answer: a EASY

5. (18.2) Lease payments FI Answer: a EASY

6. (18.3) Off-balance sheet leasing FI Answer: a EASY

7. (18.4) Lease financing FI Answer: b EASY

8. (18.5) Leveraged lease FI Answer: b EASY

9. (18.1) Synthetic leases FI Answer: b MEDIUM

10. (18.1) Synthetic leases FI Answer: a MEDIUM

11. (18.6) Residual value and lease rates FI Answer: b MEDIUM

12. (18.6) Residual value and lease rates FI Answer: b MEDIUM

13. (18.4) Lease cash flows CI Answer: c EASY

14. (18.1) Operating lease CI Answer: a MEDIUM

15. (18.1) Leasing CI Answer: e MEDIUM

16. (18.3) Capitalizing leases CI Answer: c MEDIUM

17. (18.3) Off-balance sheet leasing CI Answer: b MEDIUM

18. (18.4) Lease decision CI Answer: e MEDIUM

19. (18.4) Lease analysis discount rate CI Answer: c MEDIUM

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to a publicly accessible website, in whole or in part.

Page 8 Answers Chapter 18: Leasing

20. (18.4) Difference in payments CI Answer: c EASY

Years: 5
Loan amount: $6,000,000
Interest rate: 10.0%
Lease Pmt: $1,790,000

0 1 2 3 4 5
Loan: -$6,000,000 PMT PMT PMT PMT PMT

Find the loan payment: Financial calculator solution:

Inputs: N = 5; I/YR = 10; PV = -6,000,000; FV = 0.
Output = PMT = $1,582,785

Difference in payments = $1,790,000 – $1,582,785 = $207,215.

21. (18.4) Net advantage to leasing (NAL) CI Answer: b MEDIUM

Years: 3 Tax rate: 40%

Loan amount = equipment cost: $4,800 Maintenance costs: $240
Interest rate: 10.0% Salvage value: $0
Lease Pmt: $2,100

After tax cost of debt = Rate × (1 − T) = 6.0%

Depreciation per year = Cost/3 = $1,600
Tax saving from deprn = Deprn × T = $640

0 1 2 3
Cost of owning:
Interest -480 -480 -480
Interest tax saving 192 192 192
Maintenance -240 -240 -240
Maintenance tax saving 96 96 96
Deprn tax saving 640 640 640
Repayment of loan -4,800
Net cash loan costs 208 208 -4,592
PV cost of owning (6%): -3,474

Cost of leasing:
Lease payment -2,100 -2,100 -2,100
Tax savings from lease 840 840 840
Net cash lease costs -1,260 -1,260 -1,260
PV cost of leasing (6%): -3,368

NAL = PV Cost of Owning − PV Cost of Leasing = $106.

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to a publicly accessible website, in whole or in part.

Chapter 18: Leasing Answers Page 9

22. (18.4) Lessee's analysis CI Answer: d HARD

Life of equipment: 4 Tax rate: 40%

Loan amount = equipment cost: $40,000 Maintenance costs: $1,000
Interest rate: 10.0% Salvage value: $10,000
Lease Pmt: $10,000

Loan amortization for cash payment and interest expense:

Payment: N = 4, I/YR = 10, PV = 40000, FV = 0. PMT = -$12,618.83

Year Beg. Bal. PMT Interest Principal Ending Bal.

1 40,000 12,619 4,000 8,619 31,381
2 31,381 12,619 3,138 9,481 21,900
3 21,900 12,619 2,190 10,429 11,472
4 11,472 12,619 1,147 11,472 0

Loan Analysis: 0 1 2 3 4
MACRS factor 0.33 0.45 0.15 0.07
Depreciation 13,200 18,000 6,000 2,800

Loan Pmt -12,619 -12,619 -12,619 -12,619

Int tax saving (Int. from table  T)) 1,600 1,255 876 459
Maintenance -1,000 -1,000 -1,000 -1,000
Maint. tax saving (Maint.  T) 400 400 400 400
Depr'n tax saving (Deprn  T) 5,280 7,200 2,400 1,120
Net operating CF -6,339 -4,764 -9,943 -11,640
Salvage value 10,000
Tax on residual -4,000
Net residual val 6,000
Total Net CF -6,339 -4,764 -9,943 -5,640

PV cost of buying at I(1 – T) = 6.00% -23,035

Lease Analysis: 0 1 2 3 4
Lease payment -10,000 -10,000 -10,000 -10,000 0
Tax saving on pmt 4,000 4,000 4,000 4,000 0
Net cost of lease -6,000 -6,000 -6,000 -6,000 0
PV cost of leasing at I(1 – T) -22,038

NAL = $997

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Page 10 Answers Chapter 18: Leasing

23. (18.4) Lessee's analysis CI Answer: a HARD

Life of equipment: 3 Tax rate: 20%

Loan amount = equipment cost: $100,000 Maintenance costs: $3,000
Interest rate, simple: 10.0% Salvage value: $30,000
Lease Pmt: $29,000

Loan Analysis: 0 1 2 3 Totals

MACRS factor 0.33 0.45 0.15 0.93
Depreciation 33,000 45,000 15,000 93,000

Loan repayment -100,000

Interest -10,000 -10,000 -10,000
Int tax saving (Interest  T)) 2,000 2,000 2,000
Maintenance -3,000 -3,000 -3,000
Maint. tax saving (Maint.  T) 600 600 600
Depr'n tax saving (Deprn  T) 6,600 9,000 3,000
Net operating CF -2,400 -3,800 -1,400 -105,000
Salvage value before taxes 30,000
Book value (Cost − Total dep'rn) 7,000
Taxable salvage value 23,000
Tax on salvage value -4,600
Salvage value after taxes 25,400
Total Net CF - 2,400 -3,800 -1,400 -79,600
PV cost at I(1 − T) = 8.00% -70,308

Lease Analysis: 0 1 2 3
Lease payment -29,000 -29,000 -29,000
Tax saving on pmt 5,800 5,800 5,800 0
Net cost of lease -23,200 -23,200 -23,200 0
PV cost of leasing at I(1 − T) -64,572

NAL = $5,736

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to a publicly accessible website, in whole or in part.

Chapter 18: Leasing Answers Page 11