Exam 19: Lease Financing

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

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

Which of the following statements is most CORRECT?

If a leased asset has a negative residual value,for example,as a result of a statutory requirement to dispose of an asset in an environmentally sound manner,the lessee of the asset could reasonably expect to pay a lower lease rate because the asset does not have a positive residual value.

In a synthetic lease a special purpose entity (SPE)is set up by a corporation that wants to acquire the use of an asset.The SPE borrows up to 97% of its capital,uses its funds to buy the asset,and then leases it to the sponsoring corporation on a short-term basis.This keeps both the asset and the debt off the sponsoring company's books.

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.

To finance some manufacturing tools it needs for the next 3 years,Waldrop Corporation is considering a leasing arrangement.The tools will be obsolete and worthless after 3 years.The firm will depreciate the cost of the tools on a straight-line basis over their 3-year life.It can borrow $4,800,000,the purchase price,at 10% and buy the tools,or it can make 3 equal end-of-year lease payments of $2,100,000 each and lease them.The loan obtained from the bank is a 3-year simple interest loan,with interest paid at the end of the year.The firm's tax rate is 40%.Annual maintenance costs associated with ownership are estimated at $240,000,but this cost would be borne by the lessor if it leases.What is the net advantage to leasing (NAL),in thousands? (Suggestion: Delete 3 zeros from dollars and work in thousands. )

A leveraged lease is more risky from the lessee's standpoint than an unleveraged lease.

Leasing is often referred to as off-balance sheet financing because lease payments are shown as operating expenses on a firm's income statement and,under certain conditions,leased assets and associated liabilities do not appear on the firm's balance sheet.

Operating leases often have terms that include

Financial Accounting Standards Board (FASB)Statement #13 requires that for an unqualified audit report,financial (or capital)leases must be included in the balance sheet by reporting the

Delamont Transport Company (DTC)is evaluating the merits of leasing versus purchasing a truck with a 4-year life that costs $40,000 and falls into the MACRS 3-year class.If the firm borrows and buys 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%.What is the net advantage to leasing? (Note: Assume MACRS rates for Years 1 to 4 are 0.3333,0.4445,0.15,and 0.07. )

Carmichael Cleaners needs a new steam finishing machine that costs $100,000.The company is evaluating whether it should lease or purchase the machine.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: Assume MACRS rates for Years 1 to 4 are 0.3333,0.4445,0.1481,and 0.0741. )

Under a sale and leaseback arrangement,the seller of the leased property is the lessee and the buyer is the lessor.

A synthetic lease is a combination of derivative securities and asset purchases that mimic the cash flows of an operating lease.

In the lease versus buy decision,leasing is often preferable

Assume that a piece of leased equipment has a relatively high rather than low expected residual value.From the lessee's viewpoint,it might be better to own the asset rather than lease it because with a high residual value the lessee will likely face a higher lease rate.

Heavy use of off-balance sheet lease financing will tend to

A sale and leaseback arrangement is a type of financial,or capital,lease.

Stanley Inc.must purchase $6,000,000 worth of service equipment and is weighing the merits of leasing the equipment or purchasing.The company has a zero tax rate due to tax loss carry-forwards,and is considering a 5-year,bank loan to finance the equipment.The loan has an interest rate of 10% and would be amortized over 5 years,with 5 end-of-year payments.Stanley can also lease the equipment for 5 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.