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).

2. The less profitable one because leasing provides, among other things, a mechanism for transferring
tax benefits from entities that value them less to entities that value them more.

3. Potential problems include: (1) Care must be taken in interpreting the IRR (a high or low IRR is
preferred depending on the setup of the analysis); and (2) Care must be taken to ensure the IRR under
examination is not the implicit interest rate based on the lease payments.

4. a. Leasing is a form of secured borrowing. It reduces a firm’s cost of capital only if it is cheaper
than other forms of secured borrowing. The reduction of uncertainty is not particularly relevant;
what matters is the NAL.
b. The statement is not always true. For example, a lease often requires an advance lease payment
or security deposit and may be implicitly secured by other assets of the firm.
c. Leasing would probably not disappear, since it does reduce the uncertainty about salvage value
and the transactions costs of transferring ownership. However, the use of leasing would be greatly
reduced.

5. The lease must meet the following IRS standards for the lease payments to be tax deductible:
1. The lease term must be less than 30 years. If the term is longer, the lease is considered to be a
conditional sale.
2. The lease should not contain a bargain purchase option, which the IRS interprets as an equity
interest in the asset.
3. The lease payment schedule should not provide for very high payments early and very low
payments late in the life of the lease. This would indicate that the lease is being used to avoid
taxes.
4. Renewal options should be reasonable and based on the fair market value of the asset at renewal
time. This indicates that the lease is for legitimate business purposes, not tax avoidance.

6. 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.

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

8. Regional Express Ltd.’s financial position was such that the package of leasing and buying probably
resulted in the overall best aftertax cost. In particular, Regional Express Ltd. may not have been in a

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 CHAPTER 21 -287

position to use all of its tax credits and also may not have had the credit strength to borrow and buy
the plane without facing a credit downgrade and/or substantially higher rates.

9. There is the tax motive, but, beyond this, the lessor knows that, in the event of a default, Regional
Express Ltd. would relinquish the plane, which would then be re-leased. Fungible assets, such as
planes, which can be readily reclaimed and redeployed are good candidates for leasing.

10. The plane will be re-leased to Regional Express Ltd. or another air transportation firm, used by the
lessor, or it will be sold. There is an active market for used aircraft.

Solutions to Questions and Problems

NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple
steps. Due to space and readability constraints, when these intermediate steps are included in this solutions
manual, rounding may appear to have occurred. However, the final answer for each problem is found
without rounding during any step in the problem.

Basic

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

Depreciation tax shield = ($4,300,000/4)(.21)

Depreciation tax shield = $225,750

The aftertax cost of the lease payments will be:

Aftertax lease payment = ($1,275,000)(1 – .21)

Aftertax lease payment = $1,007,250

So, the total cash flows from leasing are:

OCF = $225,750 + 1,007,250

OCF = $1,233,000

The aftertax cost of debt is:

Aftertax debt cost = .08(1 – .21)

Aftertax debt cost = .0632, or 6.32%

Using all of this information, we can calculate the NAL as:

NAL = $4,300,000 – $1,233,000(PVIFA6.32%,4)

NAL = $58,646.08

The NAL is positive so you should lease.

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

NAL = –$58,646.08

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 CHAPTER 21 -288

3. To find the maximum lease payment that would satisfy both the lessor and the lessee, we need to find
the payment that makes the NAL equal to zero. Using the NAL equation and solving for the OCF, we
find:

NAL = 0 = $4,300,000 – OCF(PVIFA6.32%,4)

OCF = $1,250,048.95

The OCF for this lease is composed of the depreciation tax shield cash flow, as well as the aftertax
lease payment. Subtracting out the depreciation tax shield cash flow we calculated earlier, we find:

Aftertax lease payment = $1,250,048.95 – 225,750

Aftertax lease payment = $1,024,298.95

Since this is the aftertax lease payment, we can now calculate the break-even pretax lease payment as:

Break-even lease payment = $1,024,298.95/(1 – .21)

Break-even lease payment = $1,296,580.95

4. If the tax rate is zero, there is no depreciation tax shield forgone. Also, the aftertax lease payment is
the same as the pretax payment, and the aftertax cost of debt is the same as the pretax cost. So:

Cost of debt = .08

Annual cost of leasing = Leasing payment = $1,275,000

The NAL to leasing with these assumptions is:

NAL = $4,300,000 – $1,275,000(PVIFA8%,4)

NAL = $77,038.28

5. We already calculated the break-even lease payment for the lessor in Problem 3. The assumption about
the lessor concerning the tax rate has not changed. So, the lessor breaks even with a payment of
$1,296,580.95

For the lessee, we need to calculate the break-even lease payment which results in a zero NAL. Using
the assumptions in Problem 4, we find:

NAL = 0 = $4,300,000 – PMT(PVIFA8%,4)

PMT = $1,298,259.46

So, the range of lease payments that would satisfy both the lessee and the lessor are:

Total payment range = $1,296,580.95 to $1,298,259.46

6. The appropriate depreciation percentages for a three-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: ($4,300,000)(.3333)(.21) + $1,007,250 = $1,308,220

Year 2: ($4,300,000)(.4445)(.21) + $1,007,250 = $1,408,634
Year 3: ($4,300,000)(.1481)(.21) + $1,007,250 = $1,140,984
Year 4: ($4,300,000)(.0741)(.21) + $1,007,250 = $1,074,162

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 CHAPTER 21 -289

NAL = $4,300,000 – $1,308,220/1.0632 – $1,408,634/1.06322 – $1,140,984/1.06323

– $1,074,162/1.06324
NAL = $33,392.96

The machine should still be leased under these assumptions. The NAL is less than in Problem 1
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 = ($625,000/5)(.21)

Depreciation tax shield = $26,250

The aftertax cost of the lease payments will be:

Aftertax lease payment = $155,000(1 – .21)

Aftertax lease payment = $122,450

So, the total cash flows from leasing are:

OCF = $26,250 + 122,450

OCF = $148,700

The aftertax cost of debt is:

Aftertax debt cost = .07(1 – .21)

Aftertax cost of debt = .0553, or 5.53%

Using all of this information, we can calculate the NAL as:

NAL = $625,000 – $148,700(PVIFA5.53%,5)

NAL = –$9,469.25

The NAL is negative, so the company should buy.

8. a. Since the lessee has an effective tax rate of zero, there is no depreciation tax shield foregone.
Also, the aftertax lease payment is the same as the pretax payment, and the aftertax cost of debt
is the same as the pretax cost. To find the most the lessee would pay, we set the NAL equal to
zero and solve for the payment. Doing so, we find the most the lessee will pay is:

NAL = 0 = $725,000 – PMT(PVIFA9%,5)

PMT = $186,392.03

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

Depreciation tax shield = ($725,000/5)(.23)

Depreciation tax shield = $33,350

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 CHAPTER 21 -290

The aftertax cost of debt is:

Aftertax debt cost = .09(1 – .23)

Aftertax debt cost = .0693, or 6.93%

Using all of this information, we can calculate the minimum lease payment for the lessor as:

NAL = 0 = $725,000 – PMT(1 – .23)(PVIFA6.93%,5) – $33,350(PVIFA6.93%,5)

PMT = $185,895.42

c. A lease payment less than $185,895.42 will give the lessor a negative NAL. A payment higher
than $186,392.03 will give the lessee a negative NAL. In either case, no deal will be struck.
Therefore, these represent the lower and upper bounds of possible lease prices during
negotiations.

Intermediate

9. The pretax cost savings are irrelevant 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 = ($8,780,000/5)(.21)

Depreciation tax shield = $368,760

And the aftertax lease payment is:

Aftertax lease payment = $1,950,000(1 – .21)

Aftertax lease payment = $1,540,500

The aftertax cost of debt is:

Aftertax cost of debt = .07(1 – .21)

Aftertax cost of debt = .0553, or 5.53%

With these cash flows, the NAL is:

NAL = $8,780,000 – 1,540,500 – $1,540,500(PVIFA5.53%,4) – $368,760(PVIFA5.53%,5)

NAL = $270,134.62

The equipment should be leased.

To find the maximum payment, we find where the NAL is equal to zero and solve for the payment.
Using X to represent the maximum payment:

NAL = 0 = $8,780,000 – X(1.0553)(PVIFA5.53%,5) – $368,760(PVIFA5.53%,5)

X = $1,600,493.57

So, the maximum pretax lease payment is:

Pretax lease payment = $1,600,493.57/(1 – .21)

Pretax lease payment = $2,025,941.23

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 CHAPTER 21 -291

10. The aftertax residual value of the asset is an opportunity cost to the leasing decision, occurring at the
end of the system’s life (Year 5). Also, the residual value is not really a debt-like cash flow, since there
is uncertainty associated with it at Year 0. Nevertheless, although a higher discount rate may be
appropriate, we’ll use the aftertax cost of debt to discount the residual value as is common in practice.
Setting the NAL equal to zero:

NAL = 0 = $8,780,000 – X(1.0553)(PVIFA5.53%,5) – 368,760(PVIFA5.53%,5) + 900,000/1.05535

X = $1,753,210.53

So, the maximum pretax lease payment is:

Pretax lease payment = $1,753,210.53/(1 – .21)

Pretax lease payment = $2,219,253.83

11. The security deposit is a cash outflow at the beginning of the lease and a cash inflow at the end of the
lease when it is returned. The NAL with these assumptions is:

NAL = $8,780,000 – 600,000 – 1,540,500 – $1,540,500(PVIFA5.53%,4) – $368,760(PVIFA5.53%,5)

+ $600,000/1.05535
NAL = $128,563.07

With the security deposit, the firm should still lease the equipment rather than buy it, because the NAL
is greater than zero. We could also solve this problem another way. From Problem 9, we know that
the NAL without the security deposit is $270,134.62, so, if we find the present value of the security
deposit, we can add this to $270,134.62. The present value of the security deposit is:

PV of security deposit = –$600,000 + $600,000/1.05535

PV of security deposit = –$141,571.55

So, the NAL with the security deposit is:

NAL = $270,134.62 – 141,571.55

NAL = $128,563.07

12. The decision to lease results in a debt capacity that is lowered by the present value of the aftertax lease
payments. The aftertax lease payment is:

Aftertax lease payment = $420,000(1 – .21)

Aftertax lease payment = $331,800

The aftertax interest rate is:

Aftertax interest rate = .06(1 – .21)

Aftertax interest rate = .0474, or 4.74%

So, the reduction in debt capacity would be:

Reduction in debt capacity = $331,800(PVIFA4.74%,6)

Reduction in debt capacity = $1,698,208.77

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 CHAPTER 21 -292

13. a. Since both companies have the same tax rate, there is only one lease payment that will result in
a zero NAL for each company. We will calculate cash flows from the depreciation tax shield
first. The depreciation tax shield is:

Depreciation tax shield = ($825,000/3)(.22)

Depreciation tax shield = $60,500

The aftertax cost of debt is:

Aftertax debt cost = .07(1 – .22)

Aftertax debt cost = .0546, or 5.46%

Using all of this information, we can calculate the lease payment as:

NAL = 0 = $825,000 – PMT(1 – .22)(PVIFA5.46%,3) – $60,500(PVIFA5.46%,3)

PMT = $314,181.92

b. To 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 D equal the annual depreciation expense.
Let N denote the length of the lease in years.
Let R equal the pretax cost of debt.

The value to the lessor is:

N
L(1 − T1 ) + D(T1 )
ValueLessor = − P +  t =1 [1 + R(1 − T1 )]t

And the value to the lessee is:

N
L(1 − T2 ) + D(T2 )
ValueLessee = P − t =1 [1 + R(1 − T2 )]t

Since all the values in both equations above are the same except T1 and T2 , we can see that the
values of the lease to its two parties will be opposite in sign only if T 1 = T2.

c. Since the lessor’s tax bracket is unchanged, the zero NAL lease payment is the same as we found
in part a. The lessee will not realize the depreciation tax shield, and the aftertax cost of debt will
be the same as the pretax cost of debt. So, the lessee’s maximum lease payment will be:

NAL = 0 = –$825,000 + PMT(PVIFA7%,3)

PMT = $314,367.62

Both parties have positive NALs for lease payments between $314,181.92 and $314,367.62.

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 CHAPTER 21 -293

14. The decision to buy or lease is made by looking at the incremental cash flows. The loan offered by the
bank merely helps you to establish the appropriate discount rate. Since the deal they are offering is the
same as the market-wide rate, you can ignore the offer and use 9 percent as the pretax discount rate.
In any capital budgeting project, you do not consider the financing which was to be applied to a specific
project. The only exception would be if a specific and special financing deal were tied to a specific
project (like a lower-than-market interest rate loan if you buy a particular car).

a. The incremental cash flows from leasing the machine are the lease payments, the tax savings on
the lease, the lost depreciation tax shield, and the saved purchase price of the machine. The lease
payments are due at the beginning of each year, so the incremental cash flows are:

Year 0 Year 1 Year 2 Year 3 Year 4

Lease:
Lease payment –$640,000 –$640,000 –$640,000 –$640,000
Tax savings on lease 153,600 153,600 153,600 153,600
Lost dep. tax shield –126,000 –126,000 –126,000 –126,000
Equipment cost 2,100,000
$1,613,600 –$612,400 –$612,400 –$612,400 –$126,000

The aftertax discount rate is:

Aftertax discount rate = .09(1 – .24)

Aftertax discount rate = .0684, or 6.84%

So, the NAL of leasing is:

NAL = $1,613,600 – $612,400(PVIFA6.84%,3) – $126,000/1.06844

NAL = –$94,942.71

Since the NAL is negative, the company should buy the equipment.

b. The company is indifferent at the lease payment which makes the NAL of the lease equal to zero.
The NAL equation of the lease is:

0 = $2,100,000 – PMT(1 – .24) – PMT(1 – .24)(PVIFA6.84%,3) – $126,000(PVIFA6.84%,4)

PMT = $605,604.52

15. a. The different borrowing rates are irrelevant. A basic tenant of capital budgeting is that the return
of a project depends on the risk of the project. Since the lease payments are affected by the
riskiness of the lessee, the lessee’s cost of debt is the appropriate interest rate for the analysis by
both companies.

b. Since both companies have the same tax rate, there is only one lease payment that will result in
a zero NAL for each company. We will calculate cash flows from the depreciation tax shield
first. The depreciation tax shield is:

Depreciation tax shield = ($745,000/3)(.21)

Depreciation tax shield = $52,150

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 CHAPTER 21 -294

The aftertax cost of debt is the lessee’s cost of debt, which is:

Aftertax debt cost = .09(1 – .21)

Aftertax debt cost = .0711, or 7.11%

Using all of this information, we can calculate the lease payment as:

NAL = 0 = $745,000 – PMT(1 – .21)(PVIFA7.11%,3) – $52,150(PVIFA7.11%,3)

PMT = $294,055.95

c. Since the lessor’s tax bracket is unchanged, the zero NAL lease payment is the same as we
found in part b. The lessee will not realize the depreciation tax shield, and the aftertax cost of
debt will be the same as the pretax cost of debt. So, the lessee’s maximum lease payment will
be:

NAL = 0 = –$745,000 + PMT(PVIFA9%,3)

PMT = $294,315.79

Both parties have a positive NAL for lease payments between $294,055.95 and $294,315.79.

16. The APR of the loan is the lease factor times 24, so:

APR = .00185(24)
APR = .0444, or 4.44%

To calculate the lease payment we first need the net capitalization cost, which is the base capitalized
cost plus any other costs, minus any down payment or rebates. So, the net capitalized cost is:

Net capitalized cost = $49,500 + 850 – 5,000

Net capitalized cost = $45,350

The depreciation charge is the net capitalized cost minus the residual value, divided by the term of the
lease, which is:

Depreciation charge = ($45,350 – 28,500)/36

Depreciation charge = $468.06

Next, we can calculate the finance charge, which is the net capitalized cost plus the residual value,
times the lease factor, or:

Finance charge = ($45,350 + 28,500)(.00185)

Finance charge = $136.62

And the taxes on each monthly payment will be:

Taxes = ($468.06 + 136.62)(.07)

Taxes = $42.33

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 CHAPTER 21 -295

The monthly lease payment is the sum of the depreciation charge, the finance charge, and taxes, which
will be:

Lease payment = $468.06 + 136.62 + 42.33

Lease payment = $647.01

Challenge

17. With a four-year loan, the annual loan payment will be

$4,300,000 = PMT(PVIFA8%,4)
PMT = $1,298,259.46

The aftertax loan payment is found by:

Aftertax payment = Pretax payment – Interest tax shield

We need to find the interest tax shield. To find this, we need a loan amortization table since the interest
payment each year is the beginning balance times the loan interest rate of 8 percent. The interest tax
shield is the interest payment times the tax rate. The amortization table for this loan is:

Beginning Interest Principal

Year Balance Total Payment Payment Payment Ending Balance
1 $4,300,000.00 $1,298,259.46 $344,000.00 $954,259.46 $3,345,740.54
2 3,345,740.54 1,298,259.46 267,659.24 1,030,600.22 2,315,140.32
3 2,315,140.32 1,298,259.46 185,211.23 1,113,048.23 1,202,092.09
4 1,202,092.09 1,298,259.46 96,167.37 1,202,092.09 0

So, the total cash flows each year are:

Aftertax Total
Year Beginning Balance Loan Payment OCF Cash Flow
1 $1,298,259.46 – $4,300,000(.08)(.21) $1,226,019.46 –$1,233,000 = –$6,980.54
2 $1,298,259.46 – $3,345,740.54(.08)(.21) $1,242,051.02 –$1,233,000 = $9,051.02
3 $1,298,259.46 – $2,315,140.32(.08)(.21) $1,259,365.10 –$1,233,000 = $26,365.10
4 $1,298,259.46 – $1,202,092.09(.08)(.21) $1,278,064.31 –$1,233,000 = $45,064.31

So, the NAL with the loan payments is:

NAL = 0 – $6,980.54/1.0632 + $9,051.02/1.06322 + $26,365.10/1.06323 + $45,064.31/1.06324

NAL = $58,646.08

The NAL is the same as if the scanner were purchased with cash because the present value of the
aftertax loan payments, discounted at the aftertax cost of capital (which is the aftertax cost of debt)
equals $4,300,000.

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 CHAPTER 21 -296

18. a. The decision to buy or lease is made by looking at the incremental cash flows, so we need to find
the cash flows for each alternative. The cash flows if the company leases are:

Cash flows from leasing:

Aftertax cost savings = $29,000(1 – .21)

Aftertax cost savings = $22,910

The tax benefit of the lease is the lease payment times the tax rate, so the tax benefit of the lease
is:

Lease tax benefit = $80,000(.21)

Lease tax benefit = $16,800

We need to remember the lease payments are due at the beginning of the year. So, if the company
leases, the cash flows each year will be:

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Aftertax savings $22,910 $22,910 $22,910 $22,910 $22,910
Lease payment –$80,000 –80,000 –80,000 –80,000 –80,000
Tax benefit 16,800 16,800 16,800 16,800 16,800
Net cash flows –$63,200 –$40,290 –$40,290 –$40,290 –$40,290 $22,910

The amount the company borrows and the repayment schedule are irrelevant since the company
maintains a target debt-equity ratio. So, the cash flows from buying the machine will be:

Cash flows from purchasing:

Aftertax cost savings = $32,000(1 – .21)

Aftertax cost savings = $25,280

And the depreciation tax shield will be:

Depreciation tax shield = ($365,000/5)(.21)

Depreciation tax shield = $15,330

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Aftertax savings $25,280 $25,280 $25,280 $25,280 $25,280
Purchase –$365,000
Dep. tax shield 15,330 15,330 15,330 15,330 15,330
Net cash flows –$365,000 $40,610 $40,610 $40,610 $40,610 $40,610

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 CHAPTER 21 -297

Now we can calculate the incremental cash flows from leasing versus buying by subtracting the
net cash flows from buying from the net cash flows from leasing. The incremental cash flows
from leasing are:

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Lease – Buy $301,800 –$80,900 –$80,900 –$80,900 –$80,900 –$17,700

The aftertax discount rate is:

Aftertax discount rate = .10(1 – .21)

Aftertax discount rate = .0790, or 7.90%

So, the NAL of leasing is:

NAL = $301,800 – $80,900(PVIFA7.90%,4) – $17,700/1.07905

NAL = $21,149.18

Since the NAL is positive, the company should 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 1 through Year
5.

PV = $80,900(PVIFA7.90%,4) + $17,700/1.07905
PV = $280,650.82

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