Untitled Deck

Question 1

What is a lease?

Answer 1

A contractual arrangement between two parties - the lessee and the lessor

The lessee obtains the right to use a specified asset for a defined period, in exchange for regular lease payments.

Question 2

Who retains legal ownership of the asset in a lease?

Answer 2

The lessor

The lessor receives lease payments as compensation for providing access to the asset.

Question 3

What are common provisions included in lease contracts? List at least three.

Answer 3

• End-of-term purchase options
• Cancellation conditions
• Responsibilities for maintenance and servicing

These provisions outline the terms and responsibilities of both parties in the lease agreement.

Question 4

What tax benefits do the lessee and lessor receive?

Answer 4

• Lessee: tax shield from lease payments
• Lessor: tax shield and depreciation tax shield

These benefits can influence the financial attractiveness of leasing versus purchasing.

Question 5

What is a sales-type lease?

Answer 5

The lessor is also the manufacturer or authorized dealer

Such leases are often bundled with services like maintenance and upgrades.

Question 6

What defines a direct lease?

Answer 6

A third party leasing company purchases an asset chosen by the lessee

The leasing company then leases the asset to the lessee.

Question 7

What is a sale and leaseback?

Answer 7

A firm sells an asset it already owns and leases it back

This transaction unlocks capital while maintaining the right of use.

Question 8

What is a leverage lease?

Answer 8

A lender funds the acquisition of an asset

The lease payments cover both principal and interest on the loan.

Question 9

What is a synthetic lease?

Answer 9

The lessee creates a special-purpose entity (SPE) to act as lessor

This allows the lessee to achieve specific tax or accounting objectives.

Question 10

In a perfect capital market, what are the conditions for fair lease payments?

Answer 10

• No taxes
• No transaction costs
• No information asymmetries
• Competitive pricing among lessors

These conditions help determine the fair lease payments for an asset.

Question 11

What is the typical structure of lease payments?

Answer 11

Lease payments are typically made at the beginning of each period

A lease takes the form of an annuity due.

Question 12

What does a fair market value lease allow the lessee to do?

Answer 12

Purchase the asset at the end of the lease for its fair market value

The contract usually specifies a procedure for determining the fair market value.

Question 13

What is a finance lease?

Answer 13

Gives the lessee ownership of the asset at the end of the lease for a nominal price

The lessee effectively pays for the asset through lease payments.

Question 14

What is a fixed price lease?

Answer 14

Gives the lessee the option to buy the asset for an agreed price at the end of the lease

Common in consumer markets, such as car leases.

Question 15

What is a fair market value cap lease?

Answer 15

Allows the lessee to buy the asset at the end of the lease for the lesser of the fair market value or a predetermined cap price

This combines flexibility with price protection.

Question 16

What are some other lease provisions that may be included?

Answer 16

• Early cancellation options
• Buyout options
• Upgrade options

These provisions are tailored to the lessee’s needs and preferences.

Question 17

How do lease provisions affect lease payments?

Answer 17

• Provisions enhancing flexibility increase lease payments
• Provisions restricting flexibility reduce lease payments

In a perfect capital market, leasing remains a zero-NPV financing method.

Question 18

What is an operating lease?

Answer 18

Treated like a rental agreement for accounting purposes

Lease payments are reported as operating expenses on the lessee’s income statement.

Question 19

What is the tax treatment of operating leases?

Answer 19

• Lease payments are tax-deductible for the lessee
• Lessor includes lease payments as taxable income
• Lessor claims depreciation deduction on the asset

This provides a lease tax shield for the lessee.

Question 20

What criteria define a capital lease?

Answer 20

• Ownership transfers to lessee at lease end
• Lessee can purchase the asset at a bargain price
• Lease term spans 75% or more of the asset’s useful life
• Present value of lease payments is 90% or more of the asset’s fair market value

These criteria identify leases that effectively transfer the risks and rewards of ownership.

Question 21

What impact do taxes have on the leasing decision?

Answer 21

Market frictions such as taxes can make leasing more or less attractive than purchasing

This section examines the impact of taxes from the lessee’s perspective.

Question 22

In the case study, what is the corporate tax rate for TasTech Ltd?

Answer 22

30%

This rate influences the financial analysis of leasing versus purchasing.

Question 23

What are the annual lease payments for the operating lease option in the case study?

Answer 23

$27,000

The first payment is due immediately, with the remaining four at the start of each year.

Question 24

What is the purchase price of the machine in the case study?

Answer 24

$120,000

This amount is depreciated on a straight-line basis over 5 years.

Question 25

What is the **annual depreciation deduction** for the purchased machine?

Answer 25

$24,000 ## Footnote This deduction affects the tax savings from purchasing.

Question 26

What is the **free cash flow** impact of leasing the machine?

Answer 26

Net cash outflow: $18,900 per year ## Footnote This is calculated after considering tax shields from lease payments.

Question 27

What is the **initial capital outlay** for purchasing the machine?

Answer 27

$120,000 at time 0 ## Footnote This is a significant upfront cost compared to leasing.

Question 28

What is the **choice rule** for comparing leasing with a debt-financed purchase?

Answer 28

* If NPV positive → leasing better * If NPV negative → borrowing better ## Footnote This rule helps determine the more financially attractive option.

Question 29

What is the **breakeven lease payment**?

Answer 29

Payment making firm indifferent between leasing and buying ## Footnote This payment helps assess the financial viability of leasing versus purchasing.

Question 30

What are some **valid arguments for leasing**?

Answer 30

* Tax differences * Reduced resale costs * Efficiency gains from specialization ## Footnote These arguments highlight the potential benefits of leasing over purchasing.

Question 31

What shifts to the **lessor** in a leasing arrangement?

Answer 31

Resale responsibility ## Footnote The lessor is typically more efficient in resale, such as dealerships, leading to lower costs.

Question 32

How does leasing reduce **adverse selection** in resale markets?

Answer 32

By shifting resale responsibility to lessors ## Footnote Lessors specialize in resale, which helps mitigate risks associated with adverse selection.

Question 33

What are the **efficiency gains** from specialization in leasing?

Answer 33

* Lessors operate assets more efficiently * Example: leased copiers provide faster, cheaper service * Bundling services enables scale economies ## Footnote Ownership can lead to hold-up risks, while leasing preserves flexibility.

Question 34

What happens to leased assets if there is a **default**?

Answer 34

They are repossessed ## Footnote Lease obligations rank higher than secured debt, allowing lessors to recover more value.

Question 35

How does leasing affect a firm's **debt capacity**?

Answer 35

Leasing lowers risk, allowing lessors to offer better terms ## Footnote This is particularly important for small or capital-constrained firms.

Question 36

What risk is transferred to the **lessor** at the end of an asset's life?

Answer 36

Residual value risk ## Footnote This shift benefits small firms by avoiding unpredictable resale values.

Question 37

What is **debt overhang**?

Answer 37

Firms skip NPV+ projects as benefits go to creditors ## Footnote Leasing helps by being senior to existing debt, allowing firms to take blocked projects.

Question 38

What incentive alignment occurs when the **lessor** is also the manufacturer?

Answer 38

Residual risk alignment ## Footnote This motivates manufacturers to build durable, high-quality assets.

Question 39

What are some **agency problems** associated with leasing?

Answer 39

* Lessees may undermaintain assets * Raises costs for lessor ## Footnote These issues can arise despite the benefits of leasing.

Question 40

True or false: Leasing can be used to avoid scrutiny of **large capital expenditures**.

Answer 40

TRUE ## Footnote Leasing can bypass higher-level approval but may raise long-term costs.

Question 41

What is the marketing claim of leasing regarding **capital preservation**?

Answer 41

100% financing with no down payment ## Footnote The real advantage comes from frictions like distress costs and tax asymmetries.

Question 42

What is **off-balance sheet financing** in the context of leasing?

Answer 42

Structuring leases to avoid finance classification ## Footnote This keeps obligations off the balance sheet but does not eliminate real liabilities.

Question 43

What should analysts do regarding **operating leases**?

Answer 43

Treat them as leverage ## Footnote Operating leases affect firm risk and return like debt.