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Exam 18: Lease Financing

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Question 1

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Which of the following statements is most CORRECT?

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) Capital, or financial, leases generally provide for maintenance by the lessor.
E) 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.

F) A) and E)
G) A) and B)

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Question 2

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

A) True
B) False

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Question 3

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

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

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

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 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 NAL (net advantage to leasing) ? (Note: MACRS rates for Years 1 to 4 are 0.33, 0.45, 0.15, and 0.07.)

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

From the lessee viewpoint, the riskiness of the cash flows, with the possible exception of the residual value, is about the same as the riskiness of the lessee's

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.

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

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

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

Sutton Corporation, which has a zero tax rate due to tax loss carry-forwards, 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 5 end-of-year payments. Sutton 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.

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

A lease versus purchase analysis should compare the cost of leasing to the cost of owning, assuming that the asset purchased

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.

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.

In the lease versus buy decision, leasing is often preferable

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.