Chapter 20 Lease Financing Answers to End-Of-Chapter Questions

Chapter 20

Lease Financing

ANSWERS TO END-OF-CHAPTER QUESTIONS

20-1 a. The lessee is the party leasing the property. The party receiving the payments from the lease (that is, the owner of the property) is the lessor.

b. An operating lease, sometimes called a service lease, provides for both financing and maintenance. Generally, the operating lease contract is written for a period considerably shorter than the expected life of the leased equipment, and contains a cancellation clause. A financial lease does not provide for maintenance service, is not cancelable, and is fully amortized; that is, the lease covers the entire expected life of the equipment. In a sale and leaseback arrangement, the firm owning the property sells it to another firm, often a financial institution, while simulta¬neously entering into an agreement to lease the prop¬erty back from the firm. A sale and leaseback can be thought of as a type of financial lease. A combination lease combines some aspects of both operating and financial leases. For example, a financial lease which contains a cancellation clause--normally associated with operating leases--is a combination lease. In a leveraged lease, the lessor borrows a portion of the funds needed to buy the equipment to be leased.

c. Off-balance sheet financing refers to the fact that for many years neither leased assets nor the liabilities under lease contracts appeared on the lessees' balance sheets. To correct this problem, the Financial Accounting Standards Board issued FASB Statement 13. Capitalizing means incorporating the lease provisions into the balance sheet by reporting the leased asset under fixed assets and reporting the present value of future lease payments as debt.

d. FASB Statement 13 is the Financial Accounting Standards Board state¬ment (November 1976) that spells out in detail the conditions under which a lease must be capitalized, and the specific procedures to follow.

e. A guideline lease is a lease which meets all of the IRS requirements for a genuine lease. A guideline lease is often called a tax-oriented lease. If a lease meets the IRS guidelines, the IRS allows the lessor to deduct the asset's depreciation and allows the lessee to deduct the lease payments.

f. The residual value is the market value of the leased property at the expiration of the lease. The estimate of the residual value is one of the key elements in lease analysis.

g. The lessee's analysis involves determining whether leasing an asset is less costly than buying the asset. The lessee will compare the present value cost of leasing the asset with the present value cost of purchasing the asset (assuming the funds to purchase the asset are obtained through a loan). If the present value cost of the lease is less than the present value cost of purchasing, the asset should be leased. The lessee can also analyze the lease using the IRR approach. The IRR of the incremental cash flows of leasing versus purchasing represents the after-tax cost rate implied in the lease contract. If this rate is lower than the after-tax cost of debt, there is an advantage to leasing. Finally, the lessee might evaluate the lease using the equivalent loan method, which involves comparing the net savings at Time 0 if the asset is leased with the present value of the incremental costs of leasing over the term of the lease. If the Time 0 savings is greater than the present value of the incremental costs, there is an advantage to leasing.

The lessor's analysis involves determining the rate of return on the proposed lease. If the rate of return (or IRR) of the lease cash flows exceeds the lessor's opportunity cost of capital, the lease is a good investment. This is equivalent to analyzing whether the NPV of the lease is positive.

h. The net advantage to leasing (NAL) gives the dollar value of the lease to the lessee. It is, in a sense, the NPV of leasing versus owning.

i. The alternative minimum tax (AMT), which is figured at about 20 percent of the profits reported to stockholders, is a provision of the tax code that requires profitable firms to pay at least some taxes if such taxes are greater than the amount due under standard tax accounting. The AMT has provided a stimulus to leasing for those firms paying the AMT because leasing lowers profits reported to stockholders.

20-2 An operating lease is usually cancelable and includes mainten¬ance. Operating leases are, frequently, for a period signi¬ficantly shorter than the economic life of the asset, so the lessor often does not recover his full investment during the period of the basic lease. A financial lease,