Deck 18: Lease Financing

Question 1

Many leases written today combine the features of operating and financial leases. Such leases are often called "combination leases."

Answer 1

True

Question 2

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

Answer 2

True

Question 3

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.

Answer 3

True

Question 4

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

Question 5

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%. What is the NAL (net advantage to leasing)? (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

Question 6

A synthetic lease is a combination of derivative securities and asset purchases that mimic the cash flows of an operating lease.

Question 7

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) Bonds with warrants and convertible bonds both have option features that their holders can exercise if the underlying stock's price increases. However, if the option is exercised, the issuing company's debt declines if warrants were used but remains the same if it used convertibles.
B) Warrants are long-term put options that have value because holders can sell the firm's common stock at the exercise price regardless of how low the market price drops.
C) Warrants are long-term call options that have value because holders can buy the firm's common stock at the exercise price regardless of how high the stock's price has risen.
D) A firm's investors would generally prefer to see it issue bonds with warrants than straight bonds because the warrants dilute the value of new shareholders, and that value is transferred to existing shareholders.

Question 8

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

Question 9

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.

Question 10

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.

Question 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.

Question 12

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
Hard:

Question 13

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

Question 14

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

Question 15

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

Question 16

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.

Question 17

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.

Question 18

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.

Question 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.

Question 20

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.