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Chapter twenty five

Foundations of Law (University of Sydney)

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1. In a lease arrangement, the user of the asset is the

A. borrower.
B. lessee.
C. lessor.
D. lender.

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Difficulty: Basic

2. In a lease arrangement, the owner of the asset is the

A. lessor.
B. lessee.
C. borrower.
D. lender.

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Difficulty: Basic

3. A lease payment can be thought of as

A. an ordinary annuity where payments start in one year.

B. an annuity due where payments start immediately.
C. a series of unequal payments.
D. a perpetuity.

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Difficulty: Basic

4. Leveraged leases are a form of

A. operating leases.
B. financial leases.
C. leases that considerably reduce lessee's obligations.
D. rent.

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Difficulty: Basic

5. Which of the following is not a financial lease?

A. A direct lease
B. An operating lease
C. A sale-and-leaseback
D. All of the options are financial leases.

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Difficulty: Basic

6. Which of the following statements is not true?

A. The lessee does not have to buy the equipment.

B. The lessee is responsible for making the lease payments.
C. Lease payments are not tax-deductible.
D. The lessee does not have to buy the equipment, the lessee is responsible for making the lease payments,
and the lessee may give up the depreciation tax shield.

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Difficulty: Basic

7. Sale and lease-back arrangements are prevalent in

A. aircraft.
B. computers.
C. real estate.
D. standard industrial equipment.

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Difficulty: Basic

8. Firm X sold its office building and used the proceeds to improve its financial position. The firm then leased the
building back in order to continue to use the facility. This is an example of a(n)

A. operating lease.
B. sale and lease-back.
C. leveraged lease.
D. fully amortized lease.

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Difficulty: Intermediate

9. If the lessor borrows most of the purchase price of a leased asset, the lease is called a

A. leveraged lease.
B. sale and lease-back.
C. financial lease.
D. nonrecourse lease.

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Difficulty: Intermediate

10. The following are sensible reasons for leasing except

A. short-term leases are convenient.

B. standardization leads to low administrative and transaction costs for the lessor.
C. leasing preserves capital.
D. lease cancelation options are valuable.
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Difficulty: Intermediate

11. The following are sensible reasons for leasing:

A. Maintenance is provided and there is affirmation of lease cash flows during bankruptcy.
B. Maintenance is provided, there is affirmation of lease cash flows during bankruptcy., and leasing avoids
capital expenditure controls.
C. Maintenance is provided, there is affirmation of lease cash flows during bankruptcy, leasing avoids
capital expenditure controls, and alternative minimum tax can be avoided.
D. Maintenance is provided, there is affirmation of lease cash flows during bankruptcy, and alternative minimum
tax can be avoided.

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Difficulty: Intermediate

12. The following are sensible reasons for leasing:

A. Short-term leases are convenient, and standardization leads to low administrative and transaction costs for
the lessor.

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B. Short-term leases are convenient, standardization leads to low administrative and transaction costs for
the lessor, and lease cancelation options are valuable.
C. Short-term leases are convenient, standardization leads to low administrative and transaction costs for
the lessor, lease cancelation options are valuable, and tax shields can be used.
D. Short-term leases are convenient, standardization leads to low administrative and transaction costs for
the lessor, and tax shields can be used.

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Difficulty: Intermediate

13. The following are advantages to lessors over secured lenders if a lessee is under bankruptcy except

A. the bankruptcy court decides that the leased asset is essential to the lessee's business and affirms the
lease, thus paving the way for continued lease payments.
B. the lease is rejected and the lessor can recover the leased asset.
C. a lessee in financial distress may be able to renegotiate the lease, thus forcing the lessor to accept lower lease
payments.
D. All of the options are advantages to the lessor.
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14. Which of the following is probably not a good reason for leasing instead of buying?

A. Leasing may provide off-balance sheet financing.

B. Leasing may reduce administrative and transaction costs.
C. Leasing helps lessees avoid the AMT.
D. All of these options are good reasons for leasing.

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15. Which of the following motivations are dubious reasons for leasing?

A. Leasing avoids capital expenditure controls, and leasing preserves capital.

B. Leasing avoids capital expenditure controls, leasing preserves capital, and leasing can make the firm's
balance sheet and income statement look better by increasing book income or decreasing book assets or both.
C. Leasing avoids capital expenditure controls, leasing preserves capital, leasing can make the firm's balance
sheet and income statement look better by increasing book income or decreasing book assets or both, and the
alternative minimum tax is avoided.
D. Leasing avoids capital expenditure controls, leasing preserves capital, and the alternative minimum tax
is avoided.

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Difficulty: Intermediate

16. The FASB defines financial lease as leases that meet the following:

A. The lease agreement transfers ownership to the lessee before the lease expires, or the lessee can purchase the
asset for a bargain price when the lease expires.
B. The lease agreement transfers ownership to the lessee before the lease expires or the lessee can purchase the
asset for a bargain price when the lease expires, or the lease lasts for at least 75 percent of the asset's estimated
economic life.
C. The lease agreement transfers ownership to the lessee before the lease expires, or the lessee can purchase
the asset for a bargain price when the lease expires, or the lease lasts for at least 75 percent of the asset's
estimated economic life, or the present value of the lease payments is at least 90 percent of the asset's value.
D. The lessee can purchase the asset for a bargain price when the lease expires, or the lease lasts for at least 75
percent of the asset's estimated economic life, or the present value of the lease payments is at least 90 percent of
the asset's value.

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Difficulty: Challenge

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17. If the after-tax present value of buying equipment and using it for six years is $100,000, calculate the break-
even after-tax yearly lease payment (seven payments) using a 7 percent real discount rate. (Assume that lease
payments are made at the beginning of the year and zero inflation.)

A. $14,286
B. $17,341
C. $18,555
D. $19,607

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Difficulty: Intermediate

18. If the after-tax lease payment per year is $17,000, calculate the before-tax lease payments if the marginal tax
rate is 35 percent.

A. $48,571
B. $22,950
C. $26,154
D. $11,050
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Difficulty: Basic

19. If the depreciation is $20,000 and the marginal tax rate is 35 percent, calculate the annual depreciation
tax shield.

A. $20,000
B. $13,000
C. $7,000
D. $3,500

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20. If annual lease payments for a firm are $26,000, calculate the annual tax shield of these payments, given
that the marginal tax rate is 35 percent.

A. $9,100
B. $16,900
C. $40,000
D. $0

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Difficulty: Intermediate

21. If annual lease payments for a firm are $26,000, calculate the after-tax lease payments, given that the
marginal tax rate is 35 percent.

A. $9,100
B. $16,900
C. $40,000
D. $26,000

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Difficulty: Intermediate

22. You have shopped for a new car, and the best purchase price you can get is $15,000. You have been offered a
lease with 36 month-end payments of $249 and a residual value of $7,500. The interest rate that the bank would
charge you to borrow money is 9 percent (APR). What is the NPV of the lease arrangement? (Ignore taxes.)

A. $1,439

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B. $1,380
C. $406
D. $1,338

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Difficulty: Challenge

23. In a leveraged lease structure, which party is entitled to the leased asset in the event of a default on
lease payments?

A. The SPE (special-purpose entity)

B. The lessee
C. The lessor
D. The lenders to the SPE (special-purpose entity)

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Difficulty: Intermediate

24. If the interest rate on debt is rD, what discount rate should the company use when valuing financial leases?
The marginal tax rate is Tc.

A. rD(1 - Tc)
B. rDTc
C. rD
D. 1 - rDTc
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Difficulty: Challenge

25. If a firm can borrow at 9 percent, what discount rate should the firm use to discount lease cash flows? (The
marginal tax rate for the firm is 35 percent.)

A. 3.15 percent
B. 5.85 percent
C. 9 percent
D. 0 percent
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Difficulty: Basic

26. Your firm is considering leasing a new photocopier. The lease lasts for nine years. The lease calls for 10
payments of $1,000 per year with the first payment occurring immediately. The copier would cost $8,100 to buy
and would be depreciated using the straight-line method to zero salvage over nine years. The firm can borrow at a
rate of 8 percent. The corporate tax rate is 30 percent. What is the NPV of the lease?

A. -$1,039.78
B. $6,610.22
C. $686
D. $360
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Difficulty: Challenge

27. Your firm is considering leasing a magic box. The lease lasts for three years. The lease calls for three
payments of $1,350 per year with the first payment occurring at lease inception. The magic box would cost $3,600
to buy and would be straight-line depreciated to zero salvage value over three years. The firm can borrow at 6
percent, and the marginal corporate tax rate is 30 percent. What is the NPV of the lease?

A. $30.50
B. -$30.50
C. -$65.75
D. -$117.52

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Difficulty: Challenge

28. A firm is considering leasing. The firm can borrow at 9 percent, and the marginal corporate tax rate is 30
percent. What is the discount rate for valuing the lease?

A. 9 percent
B. 30 percent
C. 2.7 percent
D. 6.3 percent

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Difficulty: Intermediate

29. A computer costs $500,000 and is depreciated for tax purposes straight-line over years 1 through 5. Assume
that it has zero salvage value at the end of five years. The user wishes to lease the computer by making six
annual lease payments, the first of which is due immediately. If taxes are paid without delay and the rate of
interest is 10 percent, what is the minimum acceptable lease payment for a lessor who pays tax at 35 percent?

A. $71,905
B. $105,798
C. $123,455
D. More information is needed to solve the problem.

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Difficulty: Challenge

30. Assume the initial financing provided by a lease is $500,000 and the present value of the cash
outflow attributable to the lease is $525,000. Then the net value of the lease is

A. $25,000.
B. -$25,000.
C. $1,025,000.
D. $500,000.

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Difficulty: Intermediate

31. Assume the initial financing provided by a lease is $100,000 and the present value of the cash
outflow attributable to the lease is $90,000. Then the net value of the lease is

A. +$10,000.
B. -$10,000.
C. $190,000.
D. $100,000.

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Difficulty: Intermediate

32. If the net present value of a project is -$10,000, and the net present value of leasing for the project is +
$12,000, calculate the APV (adjusted present value) of the project.

A. -$2,000
B. $2,000
C. $12,000
D. -$10,000

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Difficulty: Intermediate

33. Suppose that a lease increases after-tax cash flows by $200,000 in each of years 1 through 10 compared with
taking out an equivalent loan to purchase the asset. All else equal, and given a usable life of 10 years with no

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salvage value, what is the advantage of the lease, given a discount rate of 7 percent (round to the nearest
$100,000)?

A. $200,000
B. $1,400,000
C. $1,800,000
D. $2,000,000

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34. The cost of a seven-year lease is $150,000 per year and matches the exact cost of a loan to finance the
purchase of equipment. All else equal, and given a usable life of seven years with no salvage value, what is the
advantage of a lease given a discount rate of 7 percent and no taxes?

A. $0
B. $800,000
C. $1,500,000
D. $2,000,000

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Difficulty: Intermediate

35. A short-term, cancelable lease is known as a financial lease. A long-term, noncancelable lease is called
an operating lease.

FALSE

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Difficulty: Intermediate

36. The user of the leased asset is called the lessee, and the owner of the asset is called the lessor.

TRUE

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Difficulty: Basic

37. Under a leveraged lease, the lessee borrows money and then uses these funds to make the lease payments.

FALSE

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Difficulty: Intermediate

38. In a sale and lease-back, the firm sells an asset that it already owns and leases it back from the buyer.

TRUE

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Difficulty: Intermediate

39. One of the sensible reasons for leasing is that short-term leases are convenient.

TRUE

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Difficulty: Intermediate

40. A lessee in financial distress may be able to renegotiate the lease and force the lessor to accept lower lease
payments.

TRUE

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Difficulty: Intermediate

41. A dubious reason for leasing is that leasing preserves capital.

TRUE

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Difficulty: Intermediate

42. The decision rule for a lease versus buy decision is "buy if the equivalent annual cost of ownership and
operation is greater than the best rate you can get from an outsider (lessor)."

FALSE

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Difficulty: Intermediate

43. Financial leases are evaluated by discounting lease cash flows at the company's WACC.

FALSE

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Difficulty: Intermediate

44. Leasing is more likely to be advantageous when the lessor's tax rate is substantially higher than the lessee's.

TRUE

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Difficulty: Intermediate

45. If lease expenses are not tax deductible, it is likely that leases will still have significant benefits to a firm.

FALSE
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Difficulty: Intermediate

46. The IRS can modify the tax code to alter the attractiveness of leases.

TRUE

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Difficulty: Intermediate

47. Discuss the differences between an operating lease and a financial lease.

Generally, operating leases are short-term leases. Operating leases are cancelable during the contract period.
Generally, financial leases are long-term leases covering the economic life of the asset and are
noncancelable. Financial leases are a source of financing.
Difficulty: Medium

48. Briefly describe a sale and lease-back arrangement.

As an example, a firm in need of cash may sell the office building it owns to a leasing company and
simultaneously sign a long-term lease agreement for the use of the office building. This is called sale and lease-
back arrangement. These transactions are common in real estate. The legal ownership of the office building is
transferred to the leasing company, but the right to use it stays with the firm.

Difficulty: Medium

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49. Briefly explain how the lessor's position changes as the lessee undergoes financial distress.

If a lessee enters default and if the bankruptcy court decides that the asset is "essential" to the lessee's business
operations, then the court "affirms" the lease. Under these circumstances, the bankrupt firm will continue to use
the asset and make the lease payments. If the lease is not affirmed, then the lessor can recover the leased asset.
There is another possibility for the lessors. That is that the lessee under financial distress may be able to
renegotiate the lease, thus compelling the lessor to accept lower lease payments.

Difficulty: Medium

50. What is the discount rate used for lease or buy analysis?
The discount rate used for discounting lease cash flows is the after-tax cost of debt rd(1 – TC) because the
alternative to leasing is borrowing.
Difficulty: Medium

51. What happens to the NPV of leasing if the tax rate increases?

At higher tax rates, the NPV of the lease will increase as the after-tax discount rate is lower (assuming that interest
rates do not change due to the tax increase). Both lessee and lessor can win if their tax rates are different—that is,
when the lessor's tax rate is substantially higher than the lessee's.

Difficulty: Difficult

52. What happens to the NPV of leasing if the lease payments increase?

The NPV of leasing will decrease if the lease payments increase. This will increase the value of the lease to the
lessor.

Difficulty: Medium

53. Discuss the critical conditions under which leasing may be advantageous.

Leasing is advantageous to the lessee when the depreciation tax shield is received early in the lease period. The
lessor"s tax rate is substantially higher than the lessee"s, and the lease period is long and the lease payments
are loaded toward the end of the period.

Difficulty: Medium

54. Briefly explain the term cross-border leases.

Generally, lessors are searching for lease arrangements that may increase the gains from leasing. Some of the
more creative leasing involves cross-border leasing arrangements. Here lessor and lessee are firms from different
countries. These arrangements take advantage of the fact that different countries define ownership differently.
This can give rise to situations where both lessor and lessee can gain from tax advantages in their respective
countries.

Difficulty: Medium
55. What advantage does a sale–lease-back to a SPE have?

The leasing company gets no cash inflows until the debt is paid off, but does get all depreciation and interest
deductions, which generate tax losses that can be used to shield other income.

Difficulty: Medium

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Category Questions
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Difficulty: Basic 11
Difficulty: Challenge 7
Difficulty: Difficult 1
Difficulty: Intermediate 28
Difficulty: Medium 8

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