Test bank fundamentals of corporate finance 9th edition chap027

Chapter 27 - Leasing Chapter 27 Leasing Multiple Choice Questions Ron leases a car from Uptown Motors and pays $225 a month as a lease payment Which one of the following terms applies to Ron? A lessee B lessor C guarantor D trustee E manager The party who owns a leased asset is called the: A lessee B lessor C guarantor D trustee E manager Kate is leasing some equipment from Ajax Leasing for a period of one-year Ajax pays the maintenance, taxes, and insurance costs for this equipment The life of the equipment is years Which type of lease does Kate have? A open B straight C operating D financial E tax-oriented 27-1 Chapter 27 - Leasing Alfredo has a non-cancelable, five year lease on an industrial-grade sewing machine for stitching upholstery For accounting purposes, this is considered to be a capital lease The life of the sewing machine is five years Alfredo must pay all taxes and insurances related to this lease Which type of lease does Alfredo have on this sewing machine? A open B straight C operating D financial E tax-oriented A financial lease in which the lessor is the owner for tax purposes is called a(n) _ lease A open B straight C operating D tax-oriented E tax-exempt Heavy Equipment Rentals borrows money on a nonrecourse basis from The Financial Group to fund its purchases of construction equipment such as backhoes, graders, earth movers, etc This equipment is then leased to contractors The leases are classified as taxoriented leases Which one of the following terms best describes these lease of construction equipment? A leveraged lease B sale and leaseback arrangement C operating lease D perpetual lease E straight lease Brentwood Industries is selling its tool and die equipment to Upward Financial and then leasing that equipment from Upward for a period of ten years, which is the useful remaining life of the equipment Which type of lease arrangement is this? A leveraged lease B sale and leaseback C operating lease D tax-oriented lease E straight lease 27-2 Chapter 27 - Leasing You are comparing a lease to a purchase The NPV associated with this analysis is referred to as the: A open interest net present value B depreciated net present value C net advantage to leasing D profitability index E net value of purchasing Which one of the following statements is correct concerning the lease versus buy decision? A The lessor is primarily concerned with returning the asset at the end of the lease term without incurring any additional charges B The lessor is primarily concerned about the use of the asset C If Dell Computer became a lessor of its own computers it would be engaging in direct leasing D A firm should always purchase, rather than lease, any asset that has a projected positive salvage value at the end of the relevant period of use E Lessors provide a source of financing for lessees 10 In a direct lease, the lessor: I is the end user of the asset II rents the leased asset from the manufacturer III owns the asset IV is generally an independent leasing company A II and III only B I and IV only C III and IV only D II, III, and IV only E I, II, III, and IV 27-3 Chapter 27 - Leasing 11 An operating lease has which of the following characteristics? I lessee has responsibility for the maintenance and insurance II lease payments cover the full cost of the asset III economic life of the asset exceeds the lease term IV lessee can cancel the lease prior to the expiration date A I and III only B II and IV only C I and II only D III and IV only E I, II, and III only 12 A financial lease: A is generally called a capital lease by accountants B requires the lessor to maintain the asset C is a partially amortized lease D is often called a single net lease E can generally be cancelled without penalty 13 A leveraged lease is a: A lease where the lessee is the owner of the asset for tax purposes B sale and leaseback arrangement C type of operating lease D lease paid with money borrowed by the lessee E lease where the lessor borrows on a nonrecourse basis 14 Which of the following apply to the lessee of a sale and leaseback arrangement? I may have option to purchase asset at end of lease term II receives cash from the sale of the asset III maintains ownership rights IV uses the asset A I and IV only B II and III only C I, II, and IV only D II, III, and IV only E I, II, III, and IV 27-4 Chapter 27 - Leasing 15 A firm that is very cyclical in nature and requires extra equipment only during its peak periods should consider leasing that equipment using a(n) _ lease A operating B tax-oriented C sale and buyback D leveraged E financial 16 A financial lease: I is generally a fully amortized lease II usually requires the lessee to insure the asset III is generally cancelable without penalty if the lessee provides 30 days advance notice IV is referred to as a capital lease by accountants A I and III only B II and IV only C I and II only D II, III, and IV only E I, II, and IV only 17 If a firm does not expect to owe taxes for a few years and needs some equipment, the firm should: A lease the equipment and retain the tax benefits B lease the equipment with the lessor retaining the tax ownership of the asset C borrow the money to buy the asset and then depreciate it using MACRS depreciation D buy the equipment with cash and depreciate it using MACRS E buy the equipment and depreciate it straight-line over the life of the asset 18 If a lessor borrows money on a nonrecourse basis to purchase an asset that will be leased to another party, then: A the lessor is responsible for the payments on the borrowed funds whether or not the lessee pays the lease payments B the lessee must pay both the lease payment and the loan payment C the loan is considered paid in full if the lessee discontinues making the lease payments or terminates the lease early D the lessor is only obligated to make loan payments as long as the lessor is collecting the lease payments E the lessor must pursue the lessee if the lessee fails to make the agreed upon lease payments 27-5 Chapter 27 - Leasing 19 If a firm enters a sale and leaseback agreement, then: I the lessee will benefit from an immediate cash inflow II both the lessor and the lessee may benefit if the lessor can benefit more from the tax benefits of ownership than can the lessee III the lease automatically becomes a nonrecourse lease IV the lessee forfeits the right to repurchase the asset at a later date A I and III only B II and IV only C I and II only D II and III only E III and IV only 20 An operating lease: A is recorded at its net present value on the balance sheet B is recorded on the balance sheet as both an asset and a liability C is recorded at its estimated residual balance on the balance sheet D is reflected in the footnotes rather than on the balance sheet E does not appear either on a financial statement or in the footnotes 21 Which one of the following will classify a lease as a capital lease for accounting purposes? A The lease transfers ownership of the asset to the lessee by the end of the lease B The lease term is 75 percent or less of the estimated economic life of the asset C The lessee can buy the asset at fair market value at the end of the lease D The initial present value of the lease payments equals or exceeds 80 percent of the fair market value of the asset E The total of the lease payments exceeds $100,000 22 A capital lease is recorded as an asset on the balance sheet in an amount equal to: A the dollar amount of each lease payment multiplied by the total number of lease payments in the original agreement B the dollar amount of each lease payment multiplied by the number of lease payments remaining C the dollar amount of each lease payment multiplied by the number of lease payments per year D the lesser of the present value of the remaining lease payments or the cost of the asset E the future value of the lease agreement at the time the agreement was made 27-6 Chapter 27 - Leasing 23 Which one of the following correctly states one of the conditions established by the IRS for a lease to be considered valid for tax purposes? A The lease should have high payments at the beginning of the lease period and low payments at the end of the lease period B Any renewal option should be based on a value which is less than the fair market value of the asset at the time of renewal C The term of the lease must be less than 80 percent of the economic life of the asset D The lessee should have the option to purchase the asset at a discounted price at the end of the lease term E The lessor must have a reasonable expectation of earning an aftertax profit 24 The IRS will disallow any lease that: A has a lease term in excess of three years B has a term that is less than one-half of the economic life of the asset C involves a lessee that has net operating losses D appears to exist solely to defer taxes E reduces the combined tax obligations of the lessor and the lessee 25 The incremental cash flows of leasing consider which of the following? I cost of the asset II lease payment amount III applicable tax rate IV annual depreciation expense A I and III only B II and IV only C II, III, and IV only D I, II, and IV only E I, II, III, and IV 26 The relevant discount rate for evaluating a lease is the firm's: A cost of equity financing B pre-tax cost of borrowing C aftertax cost of borrowing D cost of working capital E rate of return on short-term assets 27-7 Chapter 27 - Leasing 27 Which one of the following statements is correct concerning taxes and leasing? A Tax-deferral is a legitimate reason for leasing B The lessee should be the party with the higher tax bracket C Generally speaking, lessors tend to benefit from leases while lessees not D If a firm has significant net operating losses, it should be the lessor in a lease E You should only lease an asset if the lease will be fully amortized 28 The most cited reason why firms enter into lease agreements is to: A lower taxes B improve cash flows C reduce uncertainty D avoid balance sheet reporting E bypass restrictive loan covenants 29 Which one of the following is most likely the primary reason why a lessee opts to lease an asset on a short-term basis rather than buy that asset? A keep the asset off the balance sheet B tax avoidance C lower total cost D increased collateral E nonrecourse protection 30 Fred's Garage is trying to decide whether to lease or buy some new equipment The equipment costs $48,000 and has a 6-year life The equipment will be worthless after the years and will have to be replaced The company has a tax rate of 31 percent, a cost of borrowed funds of 7.5 percent, and uses straight-line depreciation The equipment can be leased for $10,600 a year What is the amount of the aftertax lease payment? A $3,286.00 B $7,314.00 C $7,862.55 D $8,406.16 E $10,928.60 27-8 Chapter 27 - Leasing 31 Jamestown Supply is trying to decide whether to lease or buy some new equipment The equipment costs $72,000, has a 4-year life, and will be worthless after the years The equipment will be replaced The cost of borrowed funds is percent and the tax rate is 34 percent The equipment can be leased for $23,800 a year What is the amount of the aftertax lease payment? A $13,897 B $14,250 C $14,667 D $15,708 E $15,820 32 Northern Lights is trying to decide whether to lease or buy some new equipment The equipment costs $51,000, has a 5-year life, and will be worthless after the years The company has a tax rate of 34 percent, a cost of borrowed funds of 8.75 percent, and uses straight-line depreciation The equipment can be leased for $14,100 a year What is the amount of the annual depreciation tax shield? A $3,468 B $5,878 C $6,936 D $8,407 E $10,200 33 The Blue Goose is trying to decide whether to lease or buy some new refrigeration equipment for the restaurant The equipment costs $63,000, has a 7-year life and will be worthless after the years The cost of borrowed funds is 8.4 percent and the tax rate is 32 percent The equipment can be leased for $9,800 a year What is the amount of the annual depreciation tax shield if the firm uses straight-line depreciation? A $2,880 B $4,300 C $7,500 D $8,333 E $9,000 27-9 Chapter 27 - Leasing 34 Val's Pizzeria is contemplating the acquisition of some new commercial ovens The purchase price is $38,000 The equipment will be depreciated based on MACRS depreciation which allows for 33.33 percent, 44.44 percent, 14.82 percent, and 7.41 percent depreciation over years to 4, respectively The equipment will be worthless at the end of years The equipment can be leased for $12,500 a year The firm can borrow money at percent and has a 35 percent tax rate What is the amount of the depreciation tax shield in year 3? A $1,525.27 B $1,624.50 C $1,971.06 D $2,325.00 E $2,631.60 35 Jane's Floor Care is contemplating the acquisition of some new equipment for refinishing wood floors The purchase price is $74,000 The firm uses MACRS depreciation which allows for 33.33 percent, 44.44 percent, 14.82 percent, and 7.41 percent depreciation over years to 4, respectively The equipment can be leased for $24,600 a year The firm can borrow money at 9.5 percent and has a 34 percent tax rate What is the amount of the depreciation tax shield in year 4? A $1,758.09 B $1,864.36 C $1,940.80 D $2,011.67 E $2,221.08 36 Steven's Auto Detailers is trying to decide whether to lease or buy some new equipment for polishing vehicles The equipment costs $22,000, has a 3-year life, and will be worthless after the years The aftertax discount rate is 6.2 percent The annual depreciation tax shield is $1,760 and the aftertax annual lease payment is $6,650 What is the net advantage to leasing? A -$397.11 B -$248.16 C $184.92 D $315.40 E $462.84 27-10 Chapter 27 - Leasing 52 J&K Enterprises is considering either leasing or buying some new equipment The lease payments would be $3,800 a year The purchase price is $19,900 The equipment has a 6-year life after which it is expected to have a resale value of $2,100 Your firm uses straight-line depreciation, borrows money at 11.5 percent, and has a 32 percent tax rate What is the aftertax salvage value of the equipment? A $1,407 B $1,428 C $1,471 D $1,476 E $1,512 Aftertax salvage value = $2,100 (1 - 0.32) = $1,428 AACSB: Analytic Bloom's: Application Difficulty: Basic Learning Objective: 27-3 Section: 27.5 Topic: Salvage value 53 Cross Town Express is contemplating the acquisition of some new equipment The purchase price is $74,000 The equipment would be depreciated using MACRS depreciation which allows for 33.33 percent, 44.44 percent, 14.82 percent, and 7.41 percent depreciation over years to 4, respectively The equipment would be worthless after that time The equipment can be leased for $19,100 a year for years The firm can borrow money at 9.5 percent and has a 28 percent tax rate What is the incremental annual cash flow for year if the company decides to lease the equipment rather than purchase it? A -$16,823 B -$15,797 C $14,312 D $15,797 E $16,823 CF3 = -1 {[$19,100 (1 - 0.28)] + [$74,000 (0.1482) (0.28)]} = -$16,823 AACSB: Analytic Bloom's: Analysis Difficulty: Intermediate Learning Objective: 27-3 Section: 27.5 Topic: Annual cash flow - MACRS 27-53 Chapter 27 - Leasing 54 Interstate Services needs some equipment costing $61,000 The equipment has a 4-year life after which it will be worthless The firm uses MACRS depreciation which allows for 33.33 percent, 44.44 percent, 14.82 percent, and 7.41 percent depreciation over years to 4, respectively The equipment can be leased for $16,600 a year The firm can borrow money at 7.5 percent and has a 36 percent tax rate What is the incremental annual cash flow for year if the company decides to lease the equipment rather than purchase it? A -$18,897 B -$19,286 C -$19,389 D -$19,407 E -$20,383 CF2 = -1 {[$16,600 (1 - 0.36)] + [$61,000 (0.4444) (0.36)]} = -$20,383 AACSB: Analytic Bloom's: Analysis Difficulty: Intermediate Learning Objective: 27-3 Section: 27.5 Topic: Annual cash flow - MACRS 55 Morrison Industrial Tool can either lease or buy some equipment The lease payments would be $12,400 a year The purchase price is $34,900 The equipment has a 3-year life after which it is expected to have a resale value of $5,500 The firm uses straight-line depreciation over the asset's life, borrows money at percent, and has a 34 percent tax rate What is the incremental cash flow for year if the company decides to lease the equipment rather than purchase it? A -$22,405 B -$16,805 C -$12,139 D -$8,184 E -$4,905 CF1 = -1 {[$12,400 (1 - 0.34)] + [($34,900/3) (0.35)]} = -$12,139 AACSB: Analytic Bloom's: Analysis Difficulty: Intermediate Learning Objective: 27-3 Section: 27.5 Topic: Annual cash flow - SL 27-54 Chapter 27 - Leasing 56 A firm can either lease or buy some new equipment The lease payments would be $19,700 a year for years The purchase price is $72,900 The equipment has a 4-year life after which it is expected to have a resale value of $3,600 The firm uses straight-line depreciation over the life of the asset, borrows money at 11 percent, and has a 35 percent tax rate The company does not expect to owe any taxes for at least years because it has accumulated net operating losses What is the incremental cash flow for year if the company decides to lease rather than purchase the equipment? A -$29,165 B -$21,821 C -$19,700 D -$18,559 E -$17,635 CF3 = -1 ($19,700) = -$19,700 AACSB: Analytic Bloom's: Application Difficulty: Basic Learning Objective: 27-3 Section: 27.7 Topic: Annual cash flow - SL, No tax 57 Daily Enterprises is contemplating the acquisition of some new equipment The purchase price is $46,000 The company expects to sell the equipment at the end of year for $2,500 The firm uses MACRS depreciation which allows for 33.33 percent, 44.44 percent, 14.82 percent, and 7.41 percent depreciation over years to 4, respectively The equipment can be leased for $12,300 a year for years The firm can borrow money at 7.5 percent and has a 35 percent tax rate What is the incremental annual cash flow for year if the company decides to lease the equipment rather than purchase it? A -$14,434 B -$12,734 C -$10,813 D -$9,434 E -$8,766 CF4 = -1 {[$12,300 (1 - 0.35)] + [$46,000 (0.0741) (0.35)] + [$2,500 (1 - 0.35)]} = -$10,813 AACSB: Analytic Bloom's: Analysis Difficulty: Intermediate Learning Objective: 27-3 Section: 27.5 Topic: Annual cash flow - MACRS, Salvage 27-55 Chapter 27 - Leasing 58 Frank's Auto Repair can purchase a new machine for $136,000 The machine has a 4-year life and can be sold at the end of year for $15,000 Frank's uses MACRS depreciation which allows for 33.33 percent, 44.44 percent, 14.82 percent, and 7.41 percent depreciation over years to 4, respectively The equipment can be leased for $35,900 a year The firm can borrow money at 7.5 percent and has a 32 percent tax rate The company does not expect to owe any taxes for at least the next years due to net operating losses What is the incremental annual cash flow for year if the company decides to lease rather than purchase the equipment? A -$50,900 B -$35,900 C -$20,900 D $15,900 E $35,900 CF4 = -1 ($15,000 + $35,900) = -$50,900 AACSB: Analytic Bloom's: Analysis Difficulty: Intermediate Learning Objective: 27-3 Section: 27.7 Topic: Annual cash flow - MACRS, No tax, Salvage Essay Questions 59 Explain the differences between purchasing an asset and leasing an asset With a purchase, the user buys an asset from the manufacturer with the user both owning and using the asset With a lease, the lessor buys an asset from the manufacturer and then owns and leases the asset to a lessee The lessee leases and uses the asset but does not own the asset Feedback: Refer to section 27.1 AACSB: Reflective thinking Bloom's: Knowledge Difficulty: Basic Learning Objective: 27-1 Section: 27.1 Topic: Financial lease 27-56 Chapter 27 - Leasing 60 What are some "good" reasons for opting to lease rather than purchase an asset? Students should provide reasons similar to those listed in the textbook, which are: Taxes may be reduced by leasing The lease contract may reduce uncertainty Transaction costs may be lower with leasing Leasing may require fewer restrictive covenants than secured borrowing Leasing may encumber fewer assets than secured borrowing Feedback: Refer to section 27.7 AACSB: Reflective thinking Bloom's: Knowledge Difficulty: Basic Learning Objective: 27-2 Section: 27.7 Topic: Reasons for leasing 61 Explain the "leasing paradox" and also explain why leasing is or is not a "zero sum game" The leasing paradox is that, given identical tax and borrowing rates, the lessee's cash flows will be equal in size (but opposite in sign) to those of the lessor In other words, leasing would be, at best, a break-even proposition for both parties The existence of tax differentials, differential transaction costs, and different costs of borrowing are a few of the reasons that make leasing worthwhile for both parties, and not just a "zero sum game" Feedback: Refer to section 27.6 AACSB: Reflective thinking Bloom's: Comprehension Difficulty: Basic Learning Objective: 27-3 Section: 27.6 Topic: Net advantage to leasing 27-57 Chapter 27 - Leasing 62 Why might a firm opt to sell and leaseback an asset which it currently owns? The firm might opt to sell the asset to create a current cash inflow from the sale proceeds The firm might also opt to sell the asset to a lessor if the lessor can realize a greater tax savings from ownership than that realized by the current owner Feedback: Refer to section 27.1 AACSB: Reflective thinking Bloom's: Comprehension Difficulty: Basic Learning Objective: 27-2 Section: 27.1 Topic: Sale and leaseback Multiple Choice Questions 63 You work for a nuclear research laboratory that is contemplating leasing a diagnostic scanner (leasing is a very common practice with expensive, high-tech equipment) The scanner costs $3.5 million and it would be depreciated straight-line to zero over years Because of radiation contamination, it will actually be completely valueless in years You can lease it for $875,000 per year for years Assume the tax rate is 33 percent You can borrow at 10 percent before taxes What is the net advantage to leasing from your company's standpoint? A $468,216 B $491,319 C $516,007 D $530,468 E $541,747 Depreciation tax shield = ($3,500,000/4)(0.33) = $288,750 Aftertax lease payment = $875,000 (1 - 0.33) = $586,250 OCF = $288,750 + $586,250 = $875,000 Aftertax cost of debt = 0.1(1 - 0.33) = 0.067 NAL = $3,500,000 - $875,000(PVIFA6.7%, 4) = $516,007 AACSB: Analytic Bloom's: Analysis Difficulty: Basic EOC #: 27-1 Learning Objective: 27-3 Section: 27.5 Topic: Net advantage to leasing 27-58 Chapter 27 - Leasing 64 You work for a nuclear research laboratory that is contemplating leasing a diagnostic scanner (leasing is a very common practice with expensive, high-tech equipment) The scanner costs $2 million and it would be depreciated straight-line to zero over years Because of radiation contamination, it will actually be completely valueless in years You can lease it for $500,000 per year for years Assume the tax rate is 34 percent You can borrow at 10 percent before taxes What is the net advantage to leasing from the lessor's viewpoint? A -$290,988 B -$267,307 C -$248,464 D $26,228 E $103,511 Depreciation tax shield = ($2,000,000/4)(0.34) = $170,000 Aftertax lease payment = $500,000 (1 - 0.34) = $330,000 OCF = $170,000 + $330,000 = $500,000 Aftertax cost of debt = 0.1(1 - 0.34) = 0.066 NAL = -$2,000,000 + $500,000(PVIFA6.6%, 4) = $290,988 AACSB: Analytic Bloom's: Analysis Difficulty: Basic EOC #: 27-2 Learning Objective: 27-3 Section: 27.5 Topic: Net advantage to leasing 27-59 Chapter 27 - Leasing 65 You work for a nuclear research laboratory that is contemplating leasing a diagnostic scanner (leasing is a very common practice with expensive, high-tech equipment) The scanner costs $2 million and it would be depreciated straight-line to zero over years Because of radiation contamination, it will actually be completely valueless in years Assume the tax rate is 33 percent You can borrow at percent before taxes How much would the lease payment have to be in order for both the lessor and the lessee to be indifferent about the lease? A $500,000 B $521,909 C $552,200 D $563,333 E $576,477 Aftertax debt cost = 0.06(1 - 0.33) = 0.0402 NAL = = $2,000,000 - OCF (PVIFA4.02%, 4); OCF = $551,239.82 Depreciation tax shield = ($2,000,000/4) (0.33) = $165,000 Aftertax lease payment = $551,239.82 - $165,000 = $386,239.82 Breakeven lease payment = $386,239.82/(1 - 0.33) = $576,477 AACSB: Analytic Bloom's: Analysis Difficulty: Basic EOC #: 27-3 Learning Objective: 27-3 Section: 27.5 Topic: Break-even lease payment 27-60 Chapter 27 - Leasing 66 You work for a nuclear research laboratory that is contemplating leasing a diagnostic scanner (leasing is a very common practice with expensive, high-tech equipment) The scanner costs $2 million and it would be depreciated straight-line to zero over years Because of radiation contamination, it will actually be completely valueless in years You can lease it for $600,000 per year for years Assume your company does not contemplate paying taxes for the next several years You can borrow at percent before taxes What is the net advantage to leasing from your company's standpoint? A -$82,711 B -$79,063 C -$21,409 D -$20,818 E -$18,315 Cost of debt = 0.06 Annual cost of leasing = $600,000 NAL = $2,000,000 -$600,000(PVIFA6%, 4) = -$79,063 AACSB: Analytic Bloom's: Analysis Difficulty: Basic EOC #: 27-4 Learning Objective: 27-3 Section: 27.5 Topic: Net advantage to leasing 27-61 Chapter 27 - Leasing 67 You work for a nuclear research laboratory that is contemplating leasing a diagnostic scanner (leasing is a very common practice with expensive, high-tech equipment) The scanner costs $3 million and it would be depreciated straight-line to zero over years Because of radiation contamination, it will actually be completely valueless in years You can lease it for $750,000 per year for years Assume the tax rate is 31 percent You can borrow at percent before taxes Your company does not expect to pay taxes for the next several years, but the leasing company will pay taxes What range of lease payments will allow the lease to be profitable for both parties? A $904,026 to $905,123 B $904,026 to $905,481 C $904,026 to $905,762 D $905,123 to $906,417 E $905,123 to $906,825 Aftertax cost of debt = 0.08(1 - 0.31) = 0.0552 NAL = = $3,000,000 - OCF (PVIFA5.52%, 4); OCF = $856,278.27 Depreciation tax shield = ($3,000,000/4) (0.31) = $232,500 Aftertax lease payment = $856,278.27 - $232,500 = $623,778.27 Breakeven lease payment = $623,778.27/(1 - 0.31) = $904,026 Since the lessor pays taxes, it will break even with a payment of $904,026 For the lessee, we need to calculate the breakeven lease payment which results in a zero NAL NAL = = $3,000,000 - PMT (PVIFA8%, 4); PMT = $905,762 Payment range = $904,026 to $905,762 AACSB: Analytic Bloom's: Analysis Difficulty: Basic EOC #: 27-5 Learning Objective: 27-3 Section: 27.5 Topic: Lease payment 27-62 Chapter 27 - Leasing 68 The Wildcat Oil Company is trying to decide whether to lease or buy a new computerassisted drilling system for its oil exploration business Management has decided that it must use the system to stay competitive; it will provide $850,000 in annual pretax cost savings The system costs $8 million and will be depreciated straight-line to zero over years Wildcat's tax rate is 31 percent, and the firm can borrow at percent Lambert Leasing Company has offered to lease the drilling equipment to Wildcat for payments of $2,040,000 per year Lambert's policy is to require its lessees to make payments at the start of the year What is the maximum lease payment that would be acceptable to the company? A $1,892,497 B $ 1,893,231 C $1,904,506 D $1,906,318 E $1,911,472 The pretax cost savings are not relevant to the lease versus buy decision since the firm will definitely use the equipment and realize the savings regardless of the financing choice made Depreciation tax shield lost = ($8,000,000/5) (0.31) = $496,000 Aftertax debt cost = 0.08 (1 - 0.31) = 0.0552 NAL = = $8,000,000 - X (1.0552) (PVIFA5.52%, 5) - $496,000(PVIFA5.52%, 5); X = $1,306,329.67 Pretax lease payment = $1,306,329.67/(1 - 0.31) = $1,893,231 AACSB: Analytic Bloom's: Analysis Difficulty: Intermediate EOC #: 27-7 Learning Objective: 27-3 Section: 27.5 Topic: Lease or buy 27-63 Chapter 27 - Leasing 69 The Wildcat Oil Company is trying to decide whether to lease or buy a new computerassisted drilling system for its oil exploration business Management has decided that it must use the system to stay competitive; it will provide $550,000 in annual pretax cost savings The system costs $3 million and will be depreciated straight-line to zero over years It is estimated that the equipment will have an aftertax residual value of $500,000 at then end of the lease Wildcat's tax rate is 31 percent, and the firm can borrow at 10 percent Lambert Leasing Company has offered to lease the drilling equipment to Wildcat for payments of $940,000 per year Lambert's policy is to require its lessees to make payments at the start of the year What is the maximum lease payment that would be acceptable to the company? A $729,932 B $734,515 C $748,200 D $751,646 E $762,937 The pretax cost savings are not relevant to the lease versus buy decision since the firm will definitely use the equipment and realize the savings regardless of the financing choice made Depreciation tax shield lost = ($3,000,000/4) (0.31) = $232,500 Aftertax debt cost = 0.1 (1 - 0.31) = 0.069 NAL = = $3,000,000 - X (1.069) (PVIFA6.9%, 4) - $232,500(PVIFA6.9%, 4) - $500,000/1.0694; X = $503,652.75 Pretax lease payment = $503,652.75/(1 - 0.31) = $729,932 AACSB: Analytic Bloom's: Analysis Difficulty: Intermediate EOC #: 27-8 Learning Objective: 27-3 Section: 27.6 Topic: Leasing and salvage value 27-64 Chapter 27 - Leasing 70 The Wildcat Oil Company is trying to decide whether to lease or buy a new computerassisted drilling system for its oil exploration business Management has decided that it must use the system to stay competitive; it will provide $1.2 million in annual pretax cost savings The system costs $6.7 million and will be depreciated straight-line to zero over years Wildcat's tax rate is 35 percent, and the firm can borrow at 11 percent Lambert Leasing Company has offered to lease the drilling equipment to Wildcat for payments of $1,750,000 per year Lambert's policy is to require its lessees to make payments at the start of the year Lambert requires Wildcat to pay a $270,000 security deposit at the inception of the lease What is the NAL of leasing the equipment? A $522,408 B $541,287 C $550,318 D $561,828 E $564,719 The pretax cost savings are not relevant to the lease versus buy decision since the firm will definitely use the equipment and realize the savings regardless of the financing choice made Depreciation tax shield lost = ($6,700,000/4) (0.35) = $586,250 Aftertax lease payment = $1,750,000 (1 - 0.35) = $1,137,500 Aftertax debt cost = 0.11 (1 - 0.35) = 0.0715 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 NAL = $6,700,000 - $270,000 - $1,137,500 - $1,137,500 (PVIFA7.15% ,3) $586,250(PVIFA7.15%, 4) + $270,000/1.07154 NAL = $541,287 AACSB: Analytic Bloom's: Analysis Difficulty: Intermediate EOC #: 27-9 Learning Objective: 27-3 Section: 27.5 Topic: Deposits in leasing 27-65 Chapter 27 - Leasing 71 An asset costs $420,000 and will be depreciated in a straight-line manner over its 3-year life It will have no salvage value The corporate tax rate is 32 percent, and the appropriate interest rate is percent What lease payment amount will make the lessee and the lessor equally well off? A $145,717.08 B $154,141.11 C $157,778.03 D $162,795.34 E $165,025.50 Depreciation tax shield = ($420,000/3) (0.32) = $44,800 Aftertax debt cost = 0.08(1 - 0.32) = 0.0544 NAL = = $420,000 - PMT (1 - 0.32) (PVIFA5.44%,3) - $44,800(PVIFA5.44%,3); PMT = $162,795.34 AACSB: Analytic Bloom's: Analysis Difficulty: Intermediate EOC #: 27-10 Learning Objective: 27-3 Section: 27.5 Topic: Setting the lease price 27-66 Chapter 27 - Leasing 72 Automobiles are often leased, and several terms are unique to auto leases Suppose you are considering leasing a car The price you and the dealer agree on for the car is $32,000 This is the base capitalized cost Other costs added to the capitalized cost price include the acquisition (bank) fee, insurance, or extended warranty Assume these costs are $390 Capitalization cost reductions include any down payment, credit of trade-in, or dealer rebate Assume you make a down payment of $2,600, and there is no trade-in or rebate If you drive 11,000 miles per year, the lease-end residual value for this car will be $18,700 after three years The lease factor, which is the interest rate on the loan, is the APR of the loan divided by 2,400 (We're not really sure where the 2,400 comes from, either.) The lease factor the dealer quotes you is 0.00208 The monthly lease payment consists of three parts; a depreciation fee, a finance fee, and sales tax The depreciation fee is the net capitalization cost minus the residual value, divided by the term of the lease The net capitalization cost is the cost of the car minus any cost reductions plus any additional costs The finance fee is the net capitalization cost plus the residual, times the money factor, and the monthly sales tax is simply the monthly lease payments times the tax rate What is your monthly lease payment for a 36-month lease if the sales tax is percent? A $329.08 B $342.63 C $379.82 D $402.24 E $441.63 Net capitalized cost = $32,000 + $390 - $2,600 = $29,790 Depreciation charge = ($29,790 - $18,700)/36 = $308.06 Finance charge = ($29,790 + $18,700) (0.00208) = $100.86 Taxes = ($308.06 + $100.86) (0.08) = $32.71 Lease payment = $308.06 + $100.86 + $32.71 = $441.63 AACSB: Analytic Bloom's: Analysis Difficulty: Intermediate EOC #: 27-11 Learning Objective: 27-3 Section: 27.5 Topic: Automobile lease payment 27-67 ... base capitalized cost Other costs added to the capitalized cost price include the acquisition (bank) fee, insurance, or extended warranty Assume these costs are $390 Capitalization cost reductions