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Chapter 21 Solutions

This document contains solutions to conceptual review and critical thinking questions about leasing. It provides details on key differences between leasing and loans, off-balance sheet financing using operating leases, and examples of calculating the net present value of leasing versus buying equipment using tax benefits and cash flows over multiple periods.

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Liana Liana
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197 views3 pages

Chapter 21 Solutions

This document contains solutions to conceptual review and critical thinking questions about leasing. It provides details on key differences between leasing and loans, off-balance sheet financing using operating leases, and examples of calculating the net present value of leasing versus buying equipment using tax benefits and cash flows over multiple periods.

Uploaded by

Liana Liana
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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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
the loan is; (2) The lessee does not own the asset and cannot depreciate it for tax purposes; (3) In the
event of a default, the lessor cannot force bankruptcy; and (4) The lessee does not obtain title to the
asset at the end of the lease (absent some additional arrangement).

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
to the statements. Operating leases (those that do not meet the criteria in Question 6) provide off-
balance sheet financing. For accounting purposes, total assets will be lower and some financial ratios
may be artificially high. Financial analysts are generally not fooled by such practices. There are no
economic consequences, since the cash flows of the firm are not affected by how the lease is treated
for accounting purposes.

8. The lessee may not be able to take advantage of the depreciation tax shield and may not be able to
obtain favorable lease arrangements for “passing on” the tax shield benefits. The lessee might also
need the cash flow from the sale to meet immediate needs, but will be able to meet the lease obligation
cash flows in the future.

9. Since the relevant cash flows are all aftertax, the aftertax discount rate is appropriate.

Solutions to Questions and Problems

1. We will calculate cash flows from the depreciation tax shield first. The depreciation tax shield is:

Depreciation tax shield = ($5,800,000 / 4)(.35)


Depreciation tax shield = $507,500

The aftertax cost of the lease payments will be:

Aftertax lease payment = ($1,690,000)(1 – .35)


Aftertax lease payment = $1,098,500

So, the total cash flows from leasing are:

OCF = $507,500 + 1,098,500


OCF = $1,606,000

The aftertax cost of debt is:

Aftertax debt cost = .08(1 – .35)


Aftertax cost of debt = .052
Using all of this information, we can calculate the NAL as:

NAL = $5,800,000 – $1,606,000(PVIFA5.20%,4)


NAL = $131,561.25

The NAL is positive so you should lease.

2. If we assume the lessor has the same cost of debt and the same tax rate, the NAL to the lessor is the
negative of our company’s NAL, so:

NAL = –$131,561.25

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: ($5,800,000)(.3333)(.35) + $1,098,500 = $1,775,099


Year 2: ($5,800,000)(.4445)(.35) + $1,098,500 = $2,000,835
Year 3: ($5,800,000)(.1481)(.35) + $1,098,500 = $1,399,143
Year 4: ($5,800,000)(.0741)(.35) + $1,098,500 = $1,248,923

NAL = $5,800,000 – $1,775,099 / 1.052 – $2,000,835 / 1.0522 – $1,399,143 / 1.0523


– $1,248,923 / 1.0524
NAL = $83,268.34

The machine should still be leased. However, notice that the NAL is lower. This is because of the
accelerated tax benefits due to depreciation, which represents a cost in the decision to lease compared
to the decision to purchase.

7. We will calculate cash flows from the depreciation tax shield first. The depreciation tax shield is:

Depreciation tax shield = ($480,000 / 5)(.35)


Depreciation tax shield = $33,600

The aftertax cost of the lease payments will be:

Aftertax lease payment = ($130,000)(1 – .35)


Aftertax lease payment = $84,500

So, the total cash flows from leasing are:

OCF = $33,600 + 84,500


OCF = $118,100

The aftertax cost of debt is:

Aftertax debt cost = .09(1 – .35)


Aftertax cost of debt = .0585
Using all of this information, we can calculate the NAL as:

NAL = $480,000 – $118,100(PVIFA5.85%,5)


NAL = –$19,516.78

The NAL is negative, so the company should not lease.

9. The pretax cost savings are not relevant 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 = ($9,700,000 / 5)(.34)


Depreciation tax shield lost = $659,600

And the aftertax lease payment is:

Aftertax lease payment = $2,150,000(1 – .34)


Aftertax lease payment = $1,419,000

The aftertax cost of debt is:

Aftertax debt cost = .09(1 – .34)


Aftertax debt cost = .0594, or 5.94%

With these cash flows, the NAL is:

NAL = $9,700,000 – 1,419,000 – $1,419,000(PVIFA5.94%,4) – $659,600(PVIFA5.94%,5)


NAL = $574,235.94

The equipment should be leased.

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