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Exam 15: Lease Financing

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Question 1

Multiple Choice

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In theory, we may regard the lease alternative as a commitment to finance the asset with what level of debt?

A) 0%
B) 25%
C) 50%
D) 100%

E) None of the above
F) C) and D)

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Question 2

Multiple Choice

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What will heavy use of off-balance sheet lease financing tend to do?

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) affect the lessee's cash flows but only due to tax effects

E) All of the above
F) B) and D)

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Question 3

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Which of the following is NOT a typical design of a synthetic lease?

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

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.

If a lease is capitalized, how is it reported under International Accounting Standards IAS 17?

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

Buster's Beverages is negotiating a lease on a new piece of equipment that would cost $100,000 if purchased. The equipment falls into the MACRS 3-year class, and it would be used for 3 years and then sold, because the firm plans to move to a new facility at that time. The estimated value of the equipment after 3 years is $30,000. A maintenance contract on the equipment would cost $3,000 per year, payable at the beginning of each year. Alternatively, the firm could lease the equipment for 3 years for a lease payment of $29,000 per year, payable at the beginning of each year. The lease would include maintenance. The firm is in the 20% tax bracket, and it could obtain a 3-year simple interest loan, interest payable at the end of the year, to purchase the equipment at a before-tax cost of 10%. If there is a positive Net Advantage to Leasing the firm will lease the equipment. Otherwise, it will buy it. What is the NAL? (Note: Depreciation rates for Years 1 to 3 are 0.33, 0.45, and 0.15)

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

A lease has big impacts on the balance sheet, not the income statement.

Consider the following information: original investment = $2,500, PV of CCA tax shield = $850, PV of after-tax lease payments = $1,700. What is the NAL?

Sutton Corporation, which has a zero tax rate due to tax loss carryforwards, 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 five end-of-year payments. Sutton can also lease the equipment for five 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.

Under which circumstances should an asset be leased?

Because of down payments, it is cheaper for lessees to lease an asset than to borrow money and purchase the asset.

Which type of terms are often included in operating leases?

CCA recapture or terminal losses will not be an issue for lessors even when the lease expires.

Which type of organization are Xerox and IBM good examples of?

The after-tax cost of debt is used as the discount rate for leasing analysis, and to be consistent with the capital budgeting purposes.

A fully taxable recapture exists if the lease provides the lessee with an option to purchase the asset at a bargain price.

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 money to buy 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%. Should the firm lease or buy? (Note: Depreciation rates for Years 1 to 4 are 0.33, 0.45, 0.15, and 0.07.)