Deck 24: Leasing

Question 1

Which of the following statements is FALSE?

A) Leases may include early cancellation options that allow the lessee to end the lease early (perhaps for a fee).
B) The cost of the lease will depend on the asset's residual value, which is its book value at the end of the lease.
C) Leases may allow the lessee to trade in and upgrade the equipment to a newer model at certain points in the lease.
D) Leases may contain buyout options that allow the lessee to purchase the asset before the end of the lease term.

Answer 1

The cost of the lease will depend on the asset's residual value, which is its book value at the end of the lease.

Question 2

Use the information for the question(s) below.
Suppose the purchase price of a bulldozer is $90,000, its residual value in four years is certain to be $15,000, and there is no risk that the lessee will default on the lease. Assume that capital markets are perfect and the risk-free interest rate is 6% APR with monthly compounding.
Suppose that instead of leasing the bulldozer, the company is considering purchasing a bulldozer outright by borrowing the purchase price using a four-year annuity loan. The monthly loan payments for a four year loan to purchase the Bulldozer are closest to ________.

A) $2,115
B) $1,825
C) $1,870
D) $1,750

Answer 2

$2,115

Question 3

Which of the following statements is FALSE?

A) A lease is a contract between two parties: the lessee and the lessor.
B) Most leases involve little or no upfront payment.
C) The lessee is the owner of the asset, who is entitled to the lease payments in exchange for lending the asset.
D) At the end of the contract term, the lease specifies who will retain ownership of the asset and at what terms.

Answer 3

The lessee is the owner of the asset, who is entitled to the lease payments in exchange for lending the asset.

Question 4

The lease is treated as a capital lease (financial lease) for the lessee and must be listed on the firm's balance sheet if it satisfies any of the following conditions EXCEPT:

A) The lease contains an option to purchase the asset at its fair market value.
B) The present value of the minimum lease payments at the start of the lease is 90% or more of the asset's fair market value.
C) The title to the property transfers to the lessee at the end of the lease term.
D) The lease term is 75% or more of the estimated economic life of the asset.

Question 5

A lease that gives the lessee the option to purchase the asset at its fair market value at the termination of the lease is called a ________.

A) fair market value cap lease
B) fair market value lease
C) $1.00-out lease
D) fixed price lease

Question 6

A lease where ownership of the asset transfers to the lessee at the end of the lease for a nominal cost is called a ________.

A) fair market value cap lease
B) fixed price lease
C) $1.00-out lease
D) fair market value lease

Question 7

Use the information for the question(s) below.
Suppose the purchase price of a bulldozer is $90,000, its residual value in four years is certain to be $15,000, and there is no risk that the lessee will default on the lease. Assume that capital markets are perfect and the risk-free interest rate is 6% APR with monthly compounding.
Suppose that the bulldozer can be leased with a $1.00-out lease. The lease payments will be closest to ________.

A) 2,114
B) 1,825
C) 2,030
D) 2,103

Question 8

Calculate the monthly lease payments for a four-year $1.00-out lease of the Bulldozer.

Question 9

Which of the following statements regarding operating leases is FALSE?

A) They are also called a finance leases.
B) The lease is viewed as a rental for accounting purposes.
C) The lessee reports the entire lease payment as an operating expense.
D) They are disclosed in the footnotes of the lessee's financial statements.

Question 10

Which of the following statements is FALSE?

A) In a direct lease, the lessor is the manufacturer (or a primary dealer) of the asset.
B) The lease specifies any cancellation provisions, the options for renewal and purchase, and the obligations for maintenance and related servicing costs.
C) If a firm already owns an asset it would prefer to lease, it can arrange a sale and leaseback transaction.
D) With many leases, the lessor provides the initial capital necessary to purchase the asset, and then receives and retains the lease payments.

Question 11

Which of the following statements is FALSE?

A) Absent market imperfections, leases represent another form of zero-NPV financing available to a firm, and the Modigliani-Miller propositions apply: Leases neither increase nor decrease firm value, but serve only to divide the firm's cash flows and risks in different ways.
B) In a perfect market, the cost of leasing is equivalent to the cost of purchasing and reselling the asset.
C) Each lease agreement can be tailored to fit the precise nature of the asset and the needs of the parties at hand.
D) Features of leases will be priced as part of the lease payment. Terms that give valuable options to the lessee lower the amount of the lease payments, whereas terms that restrict these options will raise them.

Question 12

Calculate the monthly lease payments for a four year fixed price lease that allows the lessee to buy the Bulldozer at the end of the lease for $8,000.

Question 13

A lease will be treated as a nontax lease if it satisfies any of the following conditions EXCEPT:

A) The property may be acquired at the fair market value of the asset at the time when the option may be exercised.
B) Some portion of the lease payments is specifically designated as interest or its equivalent.
C) The lessee receives ownership of the asset on completion of all lease payments.
D) The total amount that the lessee is required to pay for a relatively short period of use constitutes an inordinately large proportion of the total value of the asset.

Question 14

Use the information for the question(s) below.
Suppose the purchase price of a bulldozer is $90,000, its residual value in four years is certain to be $15,000, and there is no risk that the lessee will default on the lease. Assume that capital markets are perfect and the risk-free interest rate is 6% APR with monthly compounding.
Suppose that the bulldozer can be leased with a fixed price lease that allows the lessee to buy the asset at the end of the lease for $12,000. The lease payments will be closest to ________.

A) 2,114
B) 1,825
C) 1,882
D) 2,324

Question 15

Use the information for the question(s) below.
Suppose the purchase price of a bulldozer is $90,000, its residual value in four years is certain to be $15,000, and there is no risk that the lessee will default on the lease. Assume that capital markets are perfect and the risk-free interest rate is 6% APR with monthly compounding.
The monthly lease payments for a four year lease of the Bulldozer are closest to ________.

A) $1,870
B) $1,825
C) $1,750
D) $2,115

Question 16

Which of the following statements is FALSE?

A) In a leveraged lease the lessor borrows from a bank or other lender to obtain the initial capital for the purchase, using the lease payments to pay interest and principal on the loan.
B) In some circumstances, the lessor is not an independent company but rather a separate business partnership, called a special-purpose entity (SPE), which is created by the lessor for the sole purpose of obtaining the lease.
C) In a direct lease, the lessor is not the manufacturer, but is often an independent company that specializes in purchasing assets and leasing them to customers.
D) SPEs are commonly used in synthetic leases, which are designed to obtain specific accounting and tax treatment.

Question 17

Which of the following statements is FALSE?

A) Because we are getting the entire asset when we purchase it with the loan, the loan payments are higher than the lease payments.
B) In a perfect market, the cost of leasing and then purchasing the asset is equivalent to the cost of borrowing to purchase the asset.
C) With a lease we are financing the entire cost of the asset; with a standard loan we are financing only the cost of the economic depreciation of the asset during its life.
D) The amount of the lease payment will depend on the purchase price, the residual value, and the appropriate discount rate for the cash flows.

Question 18

Which of the following statements regarding capital leases is FALSE?

A) Because capital leases increase the apparent leverage on the firm's balance sheet, firms sometimes prefer to have a lease categorized as an operating lease to keep it off the balance sheet.
B) The firm does not report the present value of the future lease payments as a liability on the balance sheet.
C) The asset acquired is listed on the lessee's balance sheet, and the lessee incurs depreciation expenses for the asset.
D) They are viewed as an acquisition for accounting purposes.

Question 19

A lease where the lessee can purchase the asset at the minimum of its fair market value and a fixed price is called a ________.

A) $1.00-out lease
B) fixed price lease
C) fair market value lease
D) fair market value cap lease

Question 20

A lease where the lessee has the option to purchase the asset at the end of the lease for a set price that is set upfront in the lease contract is called a ________.

A) fixed price lease
B) $1.00-out lease
C) fair market value lease
D) fair market value cap lease

Question 21

Which of the following statements is FALSE?

A) The decision to lease is often driven by real-world market imperfections related to leasing's accounting, tax, and legal treatment.
B) When publicly traded firms disclose leasing transactions in their financial statements, they must follow the recommendations of the Financial Accounting Standards Board (FASB).
C) In its Statement of Financial Accounting Standards No. 13 (FAS13), the FASB provides specific criteria that distinguish a true tax lease from a nontax lease.
D) The categories used to report leases on the financial statements affect the values of assets on the balance sheet, but they have no direct effect on the cash flows that result from a leasing transaction.

Question 22

Which of the following discount rates should be used for the lease versus borrow decision?

A) the risk-free rate of interest
B) the company's cost of borrowing
C) the company's after-tax cost of borrowing
D) the company's weighted average cost of capital

Question 23

Use the information for the question(s) below.
St. Martin's Hospital plans to purchase or lease a $2 million CT scanner. If purchased, the CT scanner will be depreciated on a straight-line basis over five years, after which it will be worthless. If leased, the annual lease payments will be $500,000 per year for five years. St. Martin's borrowing cost is 8%, and its tax rate is 35%.
Should St. Martin lease the scanner or borrow the funds and buy the scanner?

A) Buy the scanner; the NPV of the decision = $74,890.28.
B) Buy the scanner; the NPV of the decision = $1,749,890.28
C) Lease the scanner; the NPV of the decision = $1,812,027.19
D) Lease the scanner; the NPV of the decision = $692,559.51

Question 24

Which of the following statements regarding leases and taxes is FALSE?

A) In a nontax lease, the lessee can deduct the interest portion of the lease payments as an interest expense.
B) In a true tax lease, the lease payments are treated as revenue for the lessor.
C) In a true tax lease, the lessee receives the depreciation deductions associated with the ownership of the asset.
D) The IRS separates leases into two broad categories: true tax leases and nontax leases.

Question 25

What will Luther's balance sheet look like if they acquire the new fleet of delivery trucks using a capital lease?

Question 26

Use the information for the question(s) below.
St. Martin's Hospital plans to purchase or lease a $2 million CT scanner. If purchased, the CT scanner will be depreciated on a straight-line basis over five years, after which it will be worthless. If leased, the annual lease payments will be $500,000 per year for five years. St. Martin's borrowing cost is 8%, and its tax rate is 35%.
In the chapter, the lease versus buy decision was called an unfair comparison. Why? What is the correct comparison?

Question 27

Which of the following statements is FALSE?

A) Lease payments are a fixed obligation of the firm.
B) The risk of the lease payments is no greater than the risk of secured debt, so it is reasonable to discount the lease payments at the firm's secured borrowing rate.
C) If a firm purchases a piece of equipment, the expense is a capital expenditure. Therefore, the purchase price can be depreciated over time, generating a depreciation tax shield.
D) If the equipment is leased and the lease is a non-tax lease, there is no capital expenditure, but the lease payments are an operating expense.

Question 28

Use the table for the question(s) below.
Luther Industries currently has the following balance sheet (in Thousands of dollars):
Luther is about to add a new fleet of delivery trucks. The price of the fleet is $1.5 million.
If Luther acquires the new fleet of delivery trucks using a capital lease, Luther's debt-to-equity ratio will be closest to ________.

A) 0.66
B) 1.5
C) 0.80
D) 2.0

Question 29

Which of the following statements is FALSE?

A) We can compare leasing to buying the asset using equivalent leverage by discounting the incremental cash flows of leasing versus buying using the after-tax borrowing rate.
B) A nontax lease is attractive if it offers a better interest rate than would be available with a loan.
C) Evaluating a true tax lease is much more straightforward than evaluating a nontax lease.
D) To determine whether a nontax lease offers a better rate, we discount the lease payments at the firm's pretax borrowing rate and compare it to the purchase price of the asset.

Question 30

Use the table for the question(s) below.
Luther Industries currently has the following balance sheet (in Thousands of dollars):
Luther is about to add a new fleet of delivery trucks. The price of the fleet is $1.5 million.
Suppose the lease is a five-year fair market value lease, and the trucks have a remaining useful life of 8 years. If the monthly lease payments are $25,000 and the appropriate discount rate is 6% APR with monthly compounding, will the lease be classified as an operating lease or a capital lease for the lessee?

A) Capital lease, because the title to the property transfers to the lessee at the end of the lease term.
B) Capital lease, because the present value of the minimum lease payments at the start of the lease is 90% or more of the asset's fair value.
C) Operating lease, because the present value of the minimum lease payments at the start of the lease is less than 90% of the asset's fair value.
D) Operating lease, because the lease term is more than 75% of the estimated economic life of the asset.

Question 31

Which of the following statements regarding leases and bankruptcy is FALSE?

A) Operating and true tax leases are generally viewed as true leases by the courts, whereas capital and nontax leases are more likely to be viewed as a security interest.
B) By retaining ownership of the asset, the lessor has the right to repossess it if the lease payments are not made, even if the firm seeks bankruptcy protection.
C) If a lease contract is characterized as a true lease in bankruptcy, the lessor is in a somewhat superior position than a lender if the firm defaults.
D) If the lease is classified as a true lease in bankruptcy, then the lessee retains ownership rights over the asset.

Question 32

Use the information for the question(s) below.
St. Martin's Hospital plans to purchase or lease a $2 million CT scanner. If purchased, the CT scanner will be depreciated on a straight-line basis over five years, after which it will be worthless. If leased, the annual lease payments will be $500,000 per year for five years. St. Martin's borrowing cost is 8%, and its tax rate is 35%.
What is the amount of the lease-equivalent loan for the CT Scanner?

A) $74,890.28
B) $1,749,890.28
C) $3,487,027.19
D) $2,367,559.51

Question 33

Use the table for the question(s) below.
Luther Industries currently has the following balance sheet (in Thousands of dollars):
Luther is about to add a new fleet of delivery trucks. The price of the fleet is $1.5 million.
If Luther acquires the new fleet of delivery trucks using an operating lease, Luther's debt-to-equity ratio will be closest to ________.

A) 2.0
B) 1.5
C) 0.80
D) 0.66

Question 34

Which of the following statements is FALSE?

A) If the lease is deemed to be a true lease, the firm is assumed to have effective ownership of the asset and the asset is protected against seizure.
B) Although the legal ownership of the asset resides with the lessor, in a nontax lease the lessee receives the depreciation deductions.
C) The treatment of leased property in bankruptcy will depend on whether the lease is classified as a security interest or a true lease by the bankruptcy judge.
D) In a nontax lease, the interest portion of the lease payment is interest income for the lessor.

Question 35

Use the information for the question(s) below.
St. Martin's Hospital plans to purchase or lease a $2 million CT scanner. If purchased, the CT scanner will be depreciated on a straight-line basis over five years, after which it will be worthless. If leased, the annual lease payments will be $500,000 per year for five years. St. Martin's borrowing cost is 8%, and its tax rate is 35%.
If St. Martin purchases the CT scanner, what is the amount of the lease-equivalent loan?

Question 36

Use the information for the question(s) below.
St. Martin's Hospital plans to purchase or lease a $2 million CT scanner. If purchased, the CT scanner will be depreciated on a straight-line basis over five years, after which it will be worthless. If leased, the annual lease payments will be $500,000 per year for five years. St. Martin's borrowing cost is 8%, and its tax rate is 35%.
Is St. Martin's better off leasing the CT scanner or financing the purchase of the CT scanner with a lease-equivalent loan and by how much is St Martin's better off?

Question 37

Which of the following is considered an unfair comparison?

A) FMV lease versus $1.00-out lease
B) $1.00-out lease versus true tax lease
C) lease versus buy
D) lease versus borrow

Question 38

What will Luther's balance sheet look like if they acquire the new fleet of delivery trucks using an operating lease?

Question 39

Which of the following statements is FALSE?

A) For a lease to be attractive to both the lessee and the lessor, the gains must come from some underlying economic benefits that the leasing arrangement provides.
B) With a true tax lease, the lessor replaces depreciation and interest tax deductions with a deduction for the lease payments.
C) Generally speaking, if the asset's tax depreciation deductions are more rapid than its lease payments, a true tax lease is advantageous if the lessor is in a higher tax bracket than the lessee.
D) A tax gain occurs if the lease shifts the more valuable deductions to the party with the higher tax rate.

Question 40

Which of the following statements is FALSE?

A) The lease-equivalent loan is the loan that is required on the purchase of the asset that leaves the purchaser with the same obligations as the lessor would have.
B) Lease obligations themselves could trigger financial distress.
C) When a firm enters into a lease, it is committing to lease payments that are a fixed future obligation of the firm.
D) When a firm leases an asset, it is effectively adding leverage to its capital structure (whether or not the lease appears on the balance sheet for accounting purposes).

Question 41

Which of the following statements is FALSE?

A) Most financial analysts and sophisticated investors consider operating leases (which must be listed in the footnotes of the financial statements) to be additional sources of leverage.
B) By carefully avoiding the four criteria that define an operating lease for accounting purposes, a firm can avoid listing the long-term lease as a liability.
C) Because a lease is equivalent to a loan, the firm can increase its actual leverage without increasing the debt-to-equity ratio on its balance sheet.
D) For most large corporations, the amount of leverage the firm can obtain through a lease is unlikely to exceed the amount of leverage the firm can obtain through a loan.

Question 42

Which of the following explains why reducing leverage through off-balance sheet financing is not a valid argument for leasing?

A) Whether they appear on the balance sheet or not, lease commitments are liabilities for the firm.
B) For most large corporations, the amount of leverage the firm can obtain through a lease is unlikely to exceed the amount of leverage the firm can obtain through a loan.
C) Some companies may place limits on the dollar amounts a manager can invest over a certain period.
D) All of the above are reasons why reducing leverage through off-balance sheet financing is not a valid argument for leasing.

Question 43

Which of the following statements is FALSE?

A) By offering assets together with complementary services, lessors can achieve efficiency gains and offer attractive lease rates.
B) Assets leased under a true lease are afforded bankruptcy protection and cannot be seized in the event of default.
C) Because of the higher recovery value in the event of default, a lessor may be able to offer more attractive financing through the lease than an ordinary lender could.
D) Lessors often have efficiency advantages over lessees in maintaining or operating certain types of assets.

Question 44

Which of the following statements is FALSE?

A) If a firm only needs to use the asset for a short time, it is probably less costly to lease it than to buy and resell the asset.
B) While owners of assets are likely to resell them only if the assets are "lemons," a short-term lease can commit the user of an asset to return it regardless of its quality. In this way leases can help mitigate the adverse selection problem in the used goods market.
C) Car dealerships are in a better position to sell a used car at the end of a lease than a consumer is.
D) If the asset's tax depreciation deductions are faster than its lease payments, there are tax gains from a true tax lease if the lessor is in a lower tax bracket than the lessee.

Question 45

Which of the following is a valid argument for leasing?

A) tax differences
B) reduced resale costs
C) efficiency gains from specialization
D) All of the above are valid arguments for leasing.

Question 46

Which of the following statements is FALSE?

A) Leasing allows the party best able to bear the risk to hold it. For example, small firms with a low tolerance for risk may prefer to lease rather than purchase assets.
B) When the lessor is the manufacturer, a lease in which the lessor bears the risk of the residual value can improve incentives and lower agency costs.
C) For leases in which the lessor retains a substantial interest in the asset's residual value, the lessee has more of an incentive to take proper care of an asset that is leased rather than purchased.
D) Whether they appear on the balance sheet or not, lease commitments are a liability for the firm.