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Exam 15: Lease Financing

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Question 21

True/False

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Under International Accounting Standards IAS 17, a capital lease exists if the lease term is equal to 50% or less of the estimated economic life of the property.

A) True
B) False

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Question 22

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Which statement best describes leases?

A) Firms that use "off-balance sheet" financing, such as leasing, would show lower debt ratios if the effects of their leases were reflected in their financial statements.
B) Capitalizing a lease means that the firm issues equity capital in proportion to its current capital structure, in an amount sufficient to support the lease payment obligation.
C) The fixed charges associated with a lease can be as high as, but never greater than, the fixed payments associated with a loan.
D) A key difference between a capital lease and an operating lease is that with a capital lease, the lease payments provide the lessor with a return of the funds invested in the asset plus a return on the invested funds, whereas with an operating lease the lessor depends on the residual value to realize a full return of and on the investment.

E) A) and B)
F) None of the above

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Question 23

Multiple Choice

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In the lease versus buy decision, why is leasing often preferable?

Kohers Inc. is considering a leasing arrangement to finance some manufacturing tools that it needs for the next three years. 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.)

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.

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.

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

Given which assumption should a lease versus purchase analysis compare the cost of leasing to the cost of owning?

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

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.

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

Scenario: ABC Leasing ABC Leasing has an after-tax cost of borrowing of 10%. The company is in a 35% tax bracket. A new machine will be purchased for $100,000. The straight-line method is used to calculate depreciation. With heavy use, the salvage value is zero. The firm now wants to rent out this machine for 5 years at a required return of 15%. The first lease payment starts once the contract has been signed. Furthermore, lease payments received by the lessor are fully taxable. -Refer to Scenario: ABC Leasing. What is the required annual lease payment that the lessor must charge?

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

Which of the following statements is true?

Scenario: ABC Leasing ABC Leasing has an after-tax cost of borrowing of 10%. The company is in a 35% tax bracket. A new machine will be purchased for $100,000. The straight-line method is used to calculate depreciation. With heavy use, the salvage value is zero. The firm now wants to rent out this machine for 5 years at a required return of 15%. The first lease payment starts once the contract has been signed. Furthermore, lease payments received by the lessor are fully taxable. -Refer to Scenario: ABC Leasing. What is the net cost of this machine for the lessor as a legal owner receiving all tax benefits?

International Accounting Standards IAS 17 requires that for an unqualified audit report, financial (or capital) leases must be included in the balance sheet. How should they be reported?

When will a lower lease payment possibly arise?

Under which circumstances will a lessor likely charge higher lease rates?

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.

By entering into a lease, the lessee incurs an opportunity cost equal to the foregone CCA tax shield provided by the CCA of the asset.