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Leasing - Ch25

Corporate Finance Theory And Practice (University of Manitoba)

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Corporate Finance, 3Ce (Berk, DeMarzo, Strangeland)

Chapter 25 Leasing

25.1 The Basics of Leasing

1) Which of the following statements is false?

A) A lease is a contract between two parties: the lessee and the lessor.
B) Most leases involve little or no upfront payment.
C) The lessee is the owner of the asset, who is entitled to the lease payments in exchange
for lending the asset.
D) At the end of the contract term, the lease specifies who will retain ownership of the
asset and on what terms.
Answer: C
Explanation: C) The lessor is the owner of the asset, who is entitled to the lease payments
in exchange for lending the asset.
Diff: 1 Type: MC
Topic: 25.1 The Basics of Leasing

2) Special-purpose entity (SPE) is diminishing in Canada as accounting moves to ________.

A) International Financial Reporting Standards
B) Generally Accepted Accounting Principles
C) standards of the Canadian Institute of Chartered Accountants
D) capital cost allowance
Answer: A
Diff: 1 Type: MC
Topic: 25.1 The Basics of Leasing

3) In Canada, with the new standards, if the purpose of the SPE is solely to benefit the
related company, the SPE ________ its related company.
A) must be split up from
B) must be audited in
C) must be separated from
D) must be consolidated with
Answer: D
Diff: 1 Type: MC
Topic: 25.1 The Basics of Leasing

4) In a perfect market, where lessors compete with one another in initiating leases, the cost
of leasing is equivalent to
A) the cost of purchasing and future reselling price of the asset.
B) the future cost of purchasing and reselling the asset.
C) the cost of purchasing and reselling the asset.
D) the future cost of purchasing and future reselling price of the asset.
Answer: C
Diff: 1 Type: MC
Topic: 25.1 The Basics of Leasing

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5) With a standard loan we are financing ________, with a lease we are financing only
________ of the asset during the term of the lease.
A) the cost of the economic depreciation of the asset; the entire cost
B) the cost of the economic depreciation of the asset; a portion
C) only a portion of the asset; the cost of the economic depreciation
D) the entire cost of the asset; the cost of the economic depreciation
Answer: D
Diff: 1 Type: MC
Topic: 25.1 The Basics of Leasing

6) In a perfect market, where lessors compete with one another in initiating, the cost of
leasing and then purchasing the asset ________ the cost of borrowing to purchase the asset.
A) is greater than
B) is equivalent to
C) is less than
D) is double
Answer: B
Diff: 1 Type: MC
Topic: 25.1 The Basics of Leasing

7) Which of the following statements is false?

A) In a direct lease, the lessor is the manufacturer (or a primary dealer) of the asset.
B) The lease specifies any cancellation provisions, the options for renewal and purchase,
and the obligations for maintenance and related servicing costs.
C) If a firm already owns an asset it would prefer to lease, it can arrange a sale and
leaseback transaction.
D) With many leases, the lessor provides the initial capital necessary to purchase the asset,
and then receives and retains the lease payments.
Answer: A
Explanation: A) In a direct lease, the lessor is an independent company that owns the
asset.
Diff: 2 Type: MC
Topic: 25.1 The Basics of Leasing

8) Which of the following statements is false?

A) In a leveraged lease the lessor borrows from a bank or other lender to obtain the initial
capital for the purchase, using the lease payments to pay interest and principal on the loan.
B) In some circumstances, the lessor is not an independent company but rather a separate
business partnership, called a special-purpose entity (SPE), which is created by the lessee
for the sole purpose of obtaining the lease.
C) In a direct lease, the lessor is not the manufacturer, but is often an independent
company that specializes in purchasing assets and leasing them to customers.
D) SPEs are commonly used in synthetic leases, which are designed to obtain specific
accounting and tax treatment.
Answer: B
Explanation: B) In some circumstances, the lessee is not an independent company but
rather a separate business partnership, called a special-purpose entity (SPE), which is
created by the lessor for the sole purpose of obtaining the lease.
Diff: 3 Type: MC
Topic: 25.1 The Basics of Leasing

9) A lease that gives the lessee the option to purchase the asset at its fair market value at
the termination of the lease is called a
A) fair market value cap lease.
B) fair market value lease.
C) $1.00 out lease.
D) fixed price lease.
Answer: B
Diff: 2 Type: MC

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Topic: 25.1 The Basics of Leasing

10) A lease where ownership of the asset transfers to the lessee at the end of the lease for
a nominal cost is called a
A) fair market value cap lease.
B) fixed price lease.
C) $1.00 out lease.
D) fair market value lease.
Answer: C
Diff: 2 Type: MC
Topic: 25.1 The Basics of Leasing

11) A lease where the lessee has the option to purchase the asset at the end of the lease for
a set price that is set upfront in the lease contract is called a
A) fixed price lease.
B) $1.00 out lease.
C) fair market value lease.
D) fair market value cap lease.
Answer: A
Diff: 2 Type: MC
Topic: 25.1 The Basics of Leasing

12) A lease where the lessee can purchase the asset at the minimum of its fair market value
and a fixed price is called a
A) $1.00 out lease.
B) fixed price lease.
C) fair market value lease.
D) fair market value cap lease.
Answer: D
Diff: 3 Type: MC
Topic: 25.1 The Basics of Leasing

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13) Which of the following statements is false?

A) Because we are getting the entire asset when we purchase it with the loan, the loan
payments are higher than the lease payments.
B) In a perfect market, the cost of leasing and then purchasing the asset is equivalent to
the cost of borrowing to purchase the asset.
C) With a lease we are financing the entire cost of the asset; with a standard loan we are
financing only the cost of the economic depreciation of the asset during its life.
D) The amount of the lease payment will depend on the purchase price, the residual value,
and the appropriate discount rate for the cash flows.
Answer: C
Explanation: C) With a standard loan we are financing the entire cost of the asset; with a
lease we are financing only the cost of the economic depreciation of the asset during its
life.
Diff: 3 Type: MC
Topic: 25.1 The Basics of Leasing

14) Which of the following statements is false?

A) Absent market imperfections, leases represent another form of zero-NPV financing
available to a firm, and the Modigliani-Miller propositions apply: leases neither increase
nor decrease firm value, but serve only to divide the firm's cash flows and risks in different
ways.
B) In a perfect market, the cost of leasing is equivalent to the cost of purchasing and
reselling the asset.
C) Each lease agreement can be tailored to fit the precise nature of the asset and the needs
of the parties at hand.
D) Features of leases will be priced as part of the lease payment. Terms that give valuable
options to the lessee lower the amount of the lease payments, whereas terms that restrict
these options will raise them.
Answer: D
Explanation: D) Features of leases will be priced as part of the lease payment. Terms that
give valuable options to the lessee raise the amount of the lease payments, whereas terms
that restrict these options will lower them.
Diff: 3 Type: MC
Topic: 25.1 The Basics of Leasing

15) Which of the following statements is false?

A) Leases may include early cancellation options that allow the lessee to end the lease early
(perhaps for a fee).
B) The cost of the lease will depend on the asset's residual value, which is its book value at
the end of the lease.
C) Leases may allow the lessee to trade in and upgrade the equipment to a newer model at
certain points in the lease.
D) Leases may contain buyout options that allow the lessee to purchase the asset before
the end of the lease term.
Answer: B
Explanation: B) The cost of the lease will depend on the asset's residual value, which is its
market value at the end of the lease.
Diff: 3 Type: MC
Topic: 25.1 The Basics of Leasing

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Use the information for the question(s) below.

Suppose the purchase price of a bulldozer is $90,000, its residual value in four years is
certain to be $15,000, and there is no risk that the lessee will default on the lease. Assume
that capital markets are perfect and the risk-free interest rate is 6% APR with monthly
compounding.

16) The monthly lease payments for a four-year lease of the bulldozer are closest to:
A) $1,870
B) $1,825
C) $1,750
D) $2,115
Answer: B
Explanation: B) Set calculator to BEG mode (Annuity Due mode)
PV = 90,000
FV = -15,000
N = 48 (4 years × 12 months/year)
I = .5 (6%/12 months)
Compute PMT = $1,827.24
Diff: 2 Type: MC
Topic: 25.1 The Basics of Leasing

17) Suppose that instead of leasing the bulldozer, the company is considering purchasing a
bulldozer outright by borrowing the purchase price using a four-year annuity loan. The
monthly loan payments for a four-year loan to purchase the bulldozer are closest to:
A) $2,115
B) $1,825
C) $1,870
D) $1,750
Answer: A
Explanation: A) Set calculator to END mode (Ordinary Annuity mode)
PV = 90,000
FV = 0
N = 48 (4 years × 12 months/year)
I = .5 (6%/12 months)
Compute PMT = $2,113.65
Diff: 2 Type: MC
Topic: 25.1 The Basics of Leasing

18) Calculate the monthly lease payments for a four-year $1.00 out lease of the bulldozer.
Answer: Set calculator to BEG mode (Annuity Due mode)
PV = 90,000
FV = -1
N = 48 (4 years × 12 months/year)
I = .5 (6%/12 months)
Compute PMT = $2,103.12
Diff: 3 Type: ES
Topic: 25.1 The Basics of Leasing

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19) Calculate the monthly lease payments for a four-year fixed price lease that allows the
lessee to buy the bulldozer at the end of the lease for $8,000.
Answer: Set calculator to BEG mode (Annuity Due mode)
PV = 90,000
FV = -8,000
N = 48 (4 years × 12 months/year)
I = .5 (6%/12 months)
Compute PMT = $1,955.99
Diff: 3 Type: ES
Topic: 25.1 The Basics of Leasing

25.2 Accounting, Tax, and Legal Consequences of Leasing

1) When publicly traded firms disclose leasing transactions in their financial statements,
they must follow ________.
A) the Capital Cost Allowance (CCA)
B) the Generally Accepted Accounting Principles (GAAP)
C) the International Financial Reporting Standards (IFRS)
D) the standards of the Canadian Institute of Chartered Accountants (CICA)
Answer: D
Diff: 1 Type: MC
Topic: 25.2 Accounting, Tax, and Legal Consequences of Leasing

2) The CICA distinguishes two types of leases based on the lease terms, and this
classification determines the lease's accounting treatment. The two types of leases are
A) fixed leases and variable leases.
B) long-term leases and short-term leases.
C) operating leases and capital leases.
D) temporary leases and permanent leases.
Answer: C
Diff: 1 Type: MC
Topic: 25.2 Accounting, Tax, and Legal Consequences of Leasing

3) Under CICA, ________ is viewed as a rental for accounting purposes. In this case, the
lessee
reports the entire lease payment as an operating expense.
A) a capital lease
B) an operating lease
C) a short-term lease
D) a temporary lease
Answer: B
Diff: 1 Type: MC
Topic: 25.2 Accounting, Tax, and Legal Consequences of Leasing

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4) Under CICA, ________ is viewed as an acquisition for accounting purposes. The asset
acquired is listed on the lessee's balance sheet, and the lessee incurs depreciation
expenses for the asset.
A) a capital lease
B) an operating lease
C) a long-term lease
D) a permanent lease
Answer: A
Diff: 1 Type: MC
Topic: 25.2 Accounting, Tax, and Legal Consequences of Leasing

5) According to CICA, for a capital lease, the present value of the future lease payments is
listed as ________, and the interest portion of the lease payment is deducted as ________.
A) a tangible asset; a depreciation expense
B) a current asset; an amortization expense
C) an intangible asset; an interest expense
D) a liability; an interest expense
Answer: D
Diff: 1 Type: MC
Topic: 25.2 Accounting, Tax, and Legal Consequences of Leasing

6) Which of the following statements is false?

A) The Canada Revenue Agency (CRA) had its own classification rules under Interpretation
Bulletin IT-233R that effectively ruled on June 14, 2001, that the legal form of the contract
would be central to determining if the transaction was a sale or lease.
B) A lease contract would be treated as a lease and a sale contract would be treated as a
sale.
C) If the contract were designed strictly to avoid tax, the General Anti-Avoidance Rule
(GAAR) could be used to reassess the case.
D) The categories used to report leases in the financial statements affect the values of
assets on the balance sheet, but they have no direct effect on the cash flows that result
from a leasing transaction.
Answer: D
Diff: 2 Type: MC
Topic: 25.2 Accounting, Tax, and Legal Consequences of Leasing

7) The lease is treated as a capital lease (financial lease) for the lessee and must be listed
on the firm's balance sheet if it satisfies any of the following conditions EXCEPT:
A) The lease contains an option to purchase the asset at its fair market value.
B) The present value of the minimum lease payments at the start of the lease is 90% or
more of the asset's fair market value.
C) The title to the property transfers to the lessee at the end of the lease term.
D) The lease term is 75% or more of the estimated economic life of the asset.
Answer: A
Diff: 2 Type: MC
Topic: 25.2 Accounting, Tax, and Legal Consequences of Leasing

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8) A lease will be treated as a non-tax lease if it satisfies any of the following conditions
EXCEPT:
A) The property may be acquired for the fair market value of the asset at the time when the
option may be exercised.
B) Some portion of the lease payments is specifically designated as interest or its
equivalent.
C) The lessee receives ownership of the asset on completion of all lease payments.
D) The total amount that the lessee is required to pay for a relatively short period of use
constitutes an inordinately large proportion of the total value of the asset.
Answer: A
Diff: 2 Type: MC
Topic: 25.2 Accounting, Tax, and Legal Consequences of Leasing

9) Which of the following statements regarding operating leases is false?

A) They are also called a finance leases.
B) The lease is viewed as a rental for accounting purposes.
C) The lessee reports the entire lease payment as an operating expense.
D) They are disclosed in the footnotes of the lessee's financial statements.
Answer: A
Diff: 2 Type: MC
Topic: 25.2 Accounting, Tax, and Legal Consequences of Leasing

10) Which of the following statements regarding capital leases is false?

A) Because capital leases increase the apparent leverage on the firm's balance sheet, firms
sometimes prefer to have a lease categorized as an operating lease to keep it off the
balance sheet.
B) The firm does not report the present value of the future lease payments as a liability on
the balance sheet.
C) The asset acquired is listed on the lessee's balance sheet, and the lessee incurs
depreciation expenses for the asset.
D) They are viewed as an acquisition for accounting purposes.
Answer: B
Explanation: B) The firm reports the present value of the future lease payments as a
liability on the balance sheet.
Diff: 2 Type: MC
Topic: 25.2 Accounting, Tax, and Legal Consequences of Leasing

11) Which of the following statements is false?

A) The decision to lease is often driven by real-world market imperfections related to
leasing's accounting, tax, and legal treatment.
B) When publicly traded firms disclose leasing transactions in their financial statements,
they must follow the recommendations of the Financial Accounting Standards Board
(FASB).
C) In its Statement of Financial Accounting Standards No. 13 (FAS13), the FASB provides
specific criteria that distinguish a true tax lease from a non-tax lease.
D) The categories used to report leases on the financial statements affect the values of
assets on the balance sheet, but they have no direct effect on the cash flows that result
from a leasing transaction.
Answer: C
Explanation: C) The IRS provides specific criteria that distinguish a true tax lease from a
non-tax lease.
Diff: 2 Type: MC
Topic: 25.2 Accounting, Tax, and Legal Consequences of Leasing

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12) Which of the following statements is false?

A) If the lease is deemed to be a true lease, the firm is assumed to have effective ownership
of the asset and the asset is protected against seizure.
B) Although the legal ownership of the asset resides with the lessor, in a non-tax lease the
lessee receives the depreciation deductions.
C) The treatment of leased property in bankruptcy will depend on whether the lease is
classified as a security interest or a true lease by the bankruptcy judge.
D) In a non-tax lease, the interest portion of the lease payment is interest income for the
lessor.
Answer: A
Explanation: A) If the lease is deemed to be a security interest, the firm is assumed to have
effective ownership of the asset and the asset is protected against seizure.
Diff: 2 Type: MC
Topic: 25.2 Accounting, Tax, and Legal Consequences of Leasing

13) Which of the following statements regarding leases and bankruptcy is false?
A) Operating and true tax leases are generally viewed as true leases by the courts, whereas
capital and non-tax leases are more likely to be viewed as security interests.
B) By retaining ownership of the asset, the lessor has the right to repossess it if the lease
payments are not made, even if the firm seeks bankruptcy protection.
C) If a lease contract is characterized as a true lease in bankruptcy, the lessor is in a
somewhat superior position compared to a lender if the firm defaults.
D) If the lease is classified as a true lease in bankruptcy, then the lessee retains ownership
rights over the asset.
Answer: D
Explanation: D) If the lease is classified as a true lease in bankruptcy, then the lessor
retains ownership rights over the asset.
Diff: 3 Type: MC
Topic: 25.2 Accounting, Tax, and Legal Consequences of Leasing

14) Which of the following statements regarding leases and taxes is false?
A) In a non-tax lease, the lessee can deduct the interest portion of the lease payments as an
interest expense.
B) In a true tax lease, the lease payments are treated as revenue for the lessor.
C) In a true tax lease, the lessee receives the depreciation deductions associated with the
ownership of the asset.
D) The IRS separates leases into two broad categories: true tax leases and non-tax leases.
Answer: C
Explanation: C) In a true tax lease, the lessor receives the depreciation deductions
associated with the ownership of the asset.
Diff: 3 Type: MC
Topic: 25.2 Accounting, Tax, and Legal Consequences of Leasing

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Use the table for the question(s) below.

Luther Industries currently has the following balance sheet (in thousands of dollars):

Assets Liabilities
Cash $500 Debt $4,500
Property, Plant, and
Equipment $7,000 Equity $3,000
Total Debt plus
Total Assets $7,500 Equity $7,500

Luther is about to add a new fleet of delivery trucks. The price of the fleet is $1.5 million.

15) If Luther acquires the new fleet of delivery trucks using a capital lease, Luther's Debt
to Equity ratio will be closest to:
A) 0.66
B) 1.5
C) 0.80
D) 2.0
Answer: D
Explanation: D) If the firm acquires the fleet through a capital lease it is the same as if
Luther borrowed the money and purchased the fleet directly. The fleet is must be listed as
an asset and the lease will show up as a liability. Therefore, Luther's balance sheet will look
like:

Assets Liabilities
Cash $500 Debt $6,000
Property, Plant, and
Equipment $8,500 Equity $3,000
Total Debt plus
Total Assets $9,000 Equity $9,000

Luther's Debt to Equity ratio therefore is equal to = 2.0

Diff: 3 Type: MC
Topic: 25.2 Accounting, Tax, and Legal Consequences of Leasing

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16) If Luther acquires the new fleet of delivery trucks using an operating lease, Luther's
Debt to Equity ratio will be closest to:
A) 2.0
B) 1.5
C) 0.80
D) 0.66
Answer: B
Explanation: B) If the firm acquires the fleet through an operating lease, there is no
change in the original balance sheet. The fleet is not listed as an asset and the lease is not
viewed as a liability. The transaction is off-balance sheet and will be disclosed in a foot-
note. Therefore, Luther's balance sheet will look like:

Assets Liabilities
Cash $500 Debt $4,500
Property, Plant, and
Equipment $7,000 Equity $3,000
Total Debt plus
Total Assets $7,500 Equity $7,500

Luther's Debt to Equity ratio therefore is equal to = 1.5

Diff: 3 Type: MC
Topic: 25.2 Accounting, Tax, and Legal Consequences of Leasing

17) The CICA Handbook, Section 3065, provides specific criteria that distinguish an
operating lease from a capital lease. The lease is treated as a capital lease for the lessee
and must be listed on the firm's balance sheet if it satisfies any of the following conditions:
Answer:
1. Title to the property transfers to the lessee at the end of the lease term.
2. The lease contains an option to purchase the asset at a bargain price that is substantially
less than its fair market value.
3. The lease term is 75% or more of the estimated economic life of the asset.
4. The present value of the minimum lease payments at the start of the lease is 90% or
more of the asset's fair market value.
Diff: 3 Type: ES
Topic: 25.2 Accounting, Tax, and Legal Consequences of Leasing

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Use the table for the question(s) below.

Luther Industries currently has the following balance sheet (in thousands of dollars):

Assets Liabilities
Cash $500 Debt $4,500
Property, Plant, and
Equipment $7,000 Equity $3,000
Total Debt plus
Total Assets $7,500 Equity $7,500

Luther is about to add a new fleet of delivery trucks. The price of the fleet is $1.5 million.

18) What will Luther's balance sheet look like if they acquire the new fleet of delivery
trucks using a capital lease?
Answer: If the firm acquires the fleet through a capital lease it is the same as if Luther
borrowed the money and purchased the fleet directly. The fleet is must be listed as an asset
and the lease will show up as a liability. Therefore, Luther's balance sheet will look like:

Assets Liabilities
Cash $500 Debt $6,000
Property, Plant, and
Equipment $8,500 Equity $3,000
Total Debt plus
Total Assets $9,000 Equity $9,000
Diff: 2 Type: ES
Topic: 25.2 Accounting, Tax, and Legal Consequences of Leasing

19) What will Luther's balance sheet look like if they acquire the new fleet of delivery
trucks using an operating lease?
Answer: If the firm acquires the fleet through an operating lease, there is no change in the
original balance sheet. The fleet is not listed as an asset and the lease is not view as a
liability. The transaction is off-balance sheet and will be disclosed in a foot-note. Therefore,
Luther's balance sheet will look like:

Assets Liabilities
Cash $500 Debt $4,500
Property, Plant, and
Equipment $7,000 Equity $3,000
Total Debt plus
Total Assets $7,500 Equity $7,500
Diff: 2 Type: ES
Topic: 25.2 Accounting, Tax, and Legal Consequences of Leasing

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25.3 The Leasing Decision

1) Which of the following statements is false?

A) The lease-equivalent loan is the loan that is required on the purchase of the asset that
leaves the purchaser with the same obligations as the lessor would have.
B) Lease obligations themselves could trigger financial distress.
C) When a firm enters into a lease, it is committing to lease payments that are a fixed
future obligation of the firm.
D) When a firm leases an asset, it is effectively adding leverage to its capital structure
(whether or not the lease appears on the balance sheet for accounting purposes).
Answer: A
Explanation: A) The lease-equivalent loan is the loan that is required on the purchase of
the asset that leaves the purchaser with the same obligations as the lessee would have.
Diff: 1 Type: MC
Topic: 25.3 The Leasing Decision

2) Which of the following statements is false?

A) Lease payments are a fixed obligation of the firm.
B) The risk of the lease payments is no greater than the risk of secured debt, so it is
reasonable to discount the lease payments at the firm's secured borrowing rate.
C) If a firm purchases a piece of equipment, the expense is a capital expenditure.
Therefore, the purchase price can be depreciated over time, generating a depreciation tax
shield.
D) If the equipment is leased and the lease is a non-tax lease, there is no capital
expenditure, but the lease payments are an operating expense.
Answer: D
Explanation: D) If the equipment is leased and the lease is a true tax lease, there is no
capital expenditure, but the lease payments are an operating expense.
Diff: 1 Type: MC
Topic: 25.3 The Leasing Decision

3) In order to further understand Capital Cost Allowance (CCA), ________ of exempt assets
are referred to as ________ and other leases are referred to as non-tax leases.
A) operating leases and financial leases; true tax leases
B) temporary leases and capital leases; true tax leases
C) long-term leases and financial leases; true tax leases
D) capital leases and financial leases; true tax leases
Answer: A
Diff: 1 Type: MC
Topic: 25.3 The Leasing Decision

4) If a firm purchases a piece of equipment, the expense is ________. Therefore, the

purchase price can ________ over time, generating a CCA tax shield.
A) an operating expenditure; be an operating expense
B) an operating expenditure; be amortized
C) a capital expenditure; be depreciated
D) a capital expenditure; be an operating expense
Answer: C
Diff: 1 Type: MC
Topic: 25.3 The Leasing Decision

5) If the equipment is leased and the lease is a true tax lease, there is ________, but the
lease payments are ________.
A) capital expenditure; an operating expense
B) no capital expenditure; a depreciation expense
C) capital expenditure; an amortization expense
D) no capital expenditure; an operating expense
Answer: D

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Diff: 2 Type: MC
Topic: 25.3 The Leasing Decision

6) The cash flows of leasing differ from buying. A purchase requires a large initial outlay
followed by a series of ________. In contrast, the cost of leasing equipment ________.
A) evenly spread cash inflows over time; has more CCA tax shields
B) CCA tax shields; has more evenly spread over time
C) evenly spread cash outflows over time; has more CCA tax shields
D) evenly spread cash inflows over time; has more evenly spread cash outflows over time
Answer: B
Diff: 2 Type: MC
Topic: 25.3 The Leasing Decision

7) The risk of the lease payments is ________ the risk of secured debt, so it is reasonable to
discount the lease payments at the firm's secured borrowing rate.
A) equal to
B) no less than
C) no greater than
D) greater than
Answer: C
Diff: 2 Type: MC
Topic: 25.3 The Leasing Decision

8) The tax savings from the lease payments and from CCA deductions are also ________ cash
flows, as they are predetermined and will be realized as long as the firm generates positive
income. Therefore, a common assumption in practice is to use the firm's ________ for these
cash flows as well.
A) low-risk; borrowing rate
B) high-risk; borrowing rate
C) low-risk; required rate of return
D) high-risk; required rate of return
Answer: A
Diff: 2 Type: MC
Topic: 25.3 The Leasing Decision

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9) Which of the following statements is false?

A) We can compare leasing to buying the asset using equivalent leverage by discounting
the incremental cash flows of leasing versus buying using the after-tax borrowing rate.
B) A non-tax lease is attractive if it offers a better interest rate than would be available with
a loan.
C) Evaluating a true tax lease is much more straightforward than evaluating a non-tax
lease.
D) To determine whether a non-tax lease offers a better rate, we discount the lease
payments at the firm's pre-tax borrowing rate and compare it to the purchase price of the
asset.
Answer: C
Explanation: C) Evaluating a non-tax lease is much more straightforward than evaluating a
true tax lease.
Diff: 3 Type: MC
Topic: 25.3 The Leasing Decision

10) Under CCA, when evaluating a true tax lease, we should compare leasing to a purchase
that is financed with equivalent leverage. Which approaches are suggested?
Answer:
1. Compute the incremental cash flows for leasing versus buying, include the CCA tax
shield (if buying) and the tax deductibility of the lease payments if leasing.
2. Compute the NPV of leasing versus buying using equivalent leverage by discounting the
incremental cash flows at the after-tax borrowing rate.
Diff: 2 Type: ES
Topic: 25.3 The Leasing Decision

Use the information for the question(s) below.

St. Martin's Hospital plans to purchase or lease a $2 million dollar CT scanner. If

purchased, the CT scanner will be depreciated on a straight-line basis over five years, after
which it will be worthless. If leased, the annual lease payments will be $500,000 per year
for five years. St. Martin's borrowing cost is 8%, and its tax rate is 35%.

11) If St. Martin purchases the CT scanner, what is the amount of the lease-equivalent
loan?
Answer: First we construct the FCFs from leasing and buying. The FCFs from leasing are
the annual lease payments × (1 - τc) since these payments are deductible for tax purposes.
The FCFs from buying represent the original cost of the purchase in year 0 and the
depreciation tax shield of ($2M /
5 years) × .35. The free cash flows are as follows:

Year 0 1 2 3 4 5
FCF, Lease (325,000) (325,000) (325,000) (325,000) (325,000)
Less: FCF
Buy (2,000,000) 140,000 140,000 140,000 140,000 140,000
Lease-Buy 1,675,000 (465,000) (465,000) (465,000) (465,000) (140,000)
The amount of the lease equivalent loan is equal to the present value of the difference in
FCFs from years 1 to 5 discounted at the after-tax borrowing rate (.08)(1 - .35) = .052 or
5.2%.

LEL = + + + + = $1,749,890

Diff: 3 Type: ES
Topic: 25.3 The Leasing Decision

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12) Is St. Martin's better off leasing the CT scanner or financing the purchase of the CT
scanner with a lease-equivalent loan and by how much is St Martin's better off?
Answer: First we construct the FCFs from leasing and buying. The FCFs from leasing are
the annual lease payments × (1 - τc) since these payments are deductible for tax purposes.
The FCFs from buying represent the original cost of the purchase in year 0 and the
depreciation tax shield of ($2M / 5 years) × .35. The free cash flows are as follows:

Year 0 1 2 3 4 5
FCF, Lease (325,000) (325,000) (325,000) (325,000) (325,000)
Less: FCF
Buy (2,000,000) 140,000 140,000 140,000 140,000 140,000
Lease-Buy 1,675,000 (465,000) (465,000) (465,000) (465,000) (140,000)

The amount of the lease equivalent loan is equal to the present value of the difference in
FCFs from years 1 to 5 discounted at the after tax borrowing rate (.08)(1 - .35) = .052 or
5.2%.

LEL = + + + + = $1,749,890

Therefore, St. Martin's is better off not using the lease since $1,749,890 > $1,675,000

St. Martin's is better off by $1,749,890 - $1,650,000 = $74,890

Diff: 3 Type: ES
Topic: 25.3 The Leasing Decision

25.4 Reasons for Leasing

1) Which of the following statements is false?

A) By offering assets together with complementary services, lessors can achieve efficiency
gains and offer attractive lease rates.
B) Assets of the lessor leased under a true lease are afforded bankruptcy protection and
cannot be seized in the event of default.
C) Because of the higher recovery value in the event of default, a lessor may be able to
offer more attractive financing through the lease than an ordinary lender could.
D) Lessors often have efficiency advantages over lessees in maintaining or operating
certain types of assets.
Answer: B
Explanation: B) Assets of the lessor leased under a true lease are not afforded bankruptcy
protection and can be seized in the event of default.
Diff: 1 Type: MC
Topic: 25.4 Reasons for Leasing

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2) Which of the following statements is false?

A) For a lease to be attractive to both the lessee and the lessor, the gains must come from
some underlying economic benefits that the leasing arrangement provides.
B) With a true tax lease, the lessor replaces depreciation and interest tax deductions with a
deduction for the lease payments.
C) Generally speaking, if the asset's tax depreciation deductions are more rapid than its
lease payments, a true tax lease is advantageous if the lessor is in a higher tax bracket than
the lessee.
D) A tax gain occurs if the lease shifts the more valuable deductions to the party with the
higher tax rate.
Answer: B
Explanation: B) With a non-tax lease, the lessor replaces depreciation and interest tax
deductions with a deduction for the lease payments.
Diff: 1 Type: MC
Topic: 25.4 Reasons for Leasing

3) Which of the following statements is false?

A) If a firm only needs to use the asset for a short time, it is probably less costly to lease it
than to buy and resell the asset.
B) While owners of assets are likely to resell them only if the assets are "lemons," a short-
term lease can commit the user of an asset to return it regardless of its quality. In this way
leases can help mitigate the adverse selection problem in the used goods market.
C) Car dealerships are in a better position to sell a used car at the end of a lease than a
consumer is.
D) If the asset's tax depreciation deductions are faster than its lease payments, there are
tax gains from a true tax lease if the lessor is in a lower tax bracket than the lessee.
Answer: D
Explanation: D) If the asset's tax depreciation deductions are slower than its lease
payments, there are tax gains from a true tax lease if the lessor is in a lower tax bracket
than the lessee.
Diff: 1 Type: MC
Topic: 25.4 Reasons for Leasing

4) Generally, if the asset's CCA deductions are ________ its lease payments, a true tax lease
is ________ if the lessor is in a higher tax bracket than the lessee.
A) more rapid than; advantageous
B) more rapid than; disadvantageous
C) slower than; advantageous
D) equal to; advantageous
Answer: A
Diff: 2 Type: MC
Topic: 25.4 Reasons for Leasing

5) In general, if the asset's CCA deductions are ________ its lease payments, there are tax
________ from a true tax lease if the lessor is in a lower tax bracket than the lessee.
A) more rapid than; gains
B) slower than; losses
C) slower than; gains
D) equal to; losses
Answer: C
Diff: 3 Type: MC
Topic: 25.4 Reasons for Leasing

6) Which of the following statements is false?

A) Most financial analysts and sophisticated investors consider operating leases (which
must be listed in the footnotes of the financial statements) to be additional sources of
leverage.
B) By carefully avoiding the four criteria that define an operating lease for accounting
purposes, a firm can avoid listing the long-term lease as a liability.

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C) Because a lease is equivalent to a loan, the firm can increase its actual leverage without
increasing the debt-to-equity ratio on its balance sheet.
D) For most large corporations, the amount of leverage the firm can obtain through a lease
is unlikely to exceed the amount of leverage the firm can obtain through a loan.
Answer: B
Explanation: B) By carefully avoiding the four criteria that define a capital lease for
accounting purposes, a firm can avoid listing the long-term lease as a liability.
Diff: 3 Type: MC
Topic: 25.4 Reasons for Leasing

7) Which of the following statements is false?

A) Leasing allows the party best able to bear the risk to hold it. For example, small firms
with a low tolerance for risk may prefer to lease rather than purchase assets.
B) When the lessor is the manufacturer, a lease in which the lessor bears the risk of the
residual value can improve incentives and lower agency costs.
C) For leases in which the lessor retains a substantial interest in the asset's residual value,
the lessee has more of an incentive to take proper care of an asset that is leased rather
than purchased.
D) Whether they appear on the balance sheet or not, lease commitments are a liability for
the firm.
Answer: C
Explanation: C) For leases in which the lessee retains a substantial interest in the asset's
residual value, the lessee has more of an incentive to take proper care of an asset that is
leased rather than purchased.
Diff: 3 Type: MC
Topic: 25.4 Reasons for Leasing

8) A firm under financial stress may suffer from debt overhang whereby new profitable
capital projects may not be pursued. Leasing may allow the firm to proceed with these
projects because
A) the lease will separate the assets related to the new investment thereby negating the
claim from existing bondholders on these assets.
B) the lease will carry a lower rate of return than would be the case if the new assets were
financed using debt.
C) the lease will carry a lower rate of return than would be the case if the new assets were
financed using equity.
D) since the leaseholders carry a lower seniority than existing bondholders, lease financing
cannot be used to avoid the problem of debt overhang.
Answer: A
Diff: 2 Type: MC
Topic: 25.4 Reasons for Leasing

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