8 - 21 - Leasing

Chapter 21
Questions:
1. Off–Balance Sheet Financing What is meant by the term off–balance sheet

financing? When do leases provide such financing, and what are the accounting and
economic consequences of such activity?
Problems:
1. You work for a nuclear research laboratory that is contemplating leasing a diagnostic
scanner (leasing is a common practice with expensive, high-tech equipment). The
scanner costs $5,800,000, and it would be depreciated straight-line to zero over four
years. Because of radiation contamination, it will actually be completely valueless in
four years. You can lease it for $1,690,000 per year for four years.
a. Lease or Buy Assume that the tax rate is 35 percent. You can borrow at 8 percent
before taxes. Should you lease or buy?
b. Leasing Cash Flows What are the cash flows from the lease from the lessor’s
viewpoint? Assume a 35 percent tax bracket.
c. Taxes and Leasing Cash Flows Assume that your company does not
contemplate paying taxes for the next several years. What are the cash flows from
leasing in this case?
d. Setting the Lease Payment In part (c), over what range of lease payments will
the lease be profitable for both parties?
2. Lease or Buy Super Sonics Entertainment is considering buying a machine that costs
$480,000. The machine will be depreciated over five years by the straight-line method
and will be worthless at that time. The company can lease the machine with year-end
payments of $130,000. The company can issue bonds at an interest rate of 9 percent. If
the corporate tax rate is 35 percent, should the company buy or lease?
3. Setting the Lease Payment Quartz Corporation is a relatively new firm. Quartz has
experienced enough losses during its early years to provide it with at least eight years
of tax loss carryforwards. Thus, Quartz’s effective tax rate is zero. Quartz plans to
lease equipment from New Leasing Company. The term of the lease is five years. The
purchase cost of the equipment is $720,000. New Leasing Company is in the 35
percent tax bracket. There are no transaction costs to the lease. Each firm can borrow
at 10 percent.
a. What is Quartz’s reservation price?

b. What is New Leasing Company’s reservation price?
c. Explain why these reservation prices determine the negotiating range of the lease.
4. Setting the Lease Price An asset costs $720,000 and will be depreciated in a straight-
line manner over its three-year life. It will have no salvage value. The corporate tax
rate is 34 percent, and the appropriate interest rate is 10 percent.
a. What set of lease payments will make the lessee and the lessor equally well off?
b. Assume that the lessee pays no taxes and the lessor is in the 34 percent tax
bracket. For what range of lease payments does the lease have a positive NPV for
both parties?
5. Lease or Buy Wolfson Corporation has decided to purchase a new machine that costs
$2.8 million. The machine will be depreciated on a straight-line basis and will be
worthless after four years. The corporate tax rate is 35 percent. The Sur Bank has
offered Wolfson a four-year loan for $2.8 million. The repayment schedule is four
yearly principal repayments of $700,000 and an interest charge of 9 percent on the
outstanding balance of the loan at the beginning of each year. Both principal
repayments and interest are due at the end of each year. Cal Leasing Corporation
offers to lease the same machine to Wolfson. Lease payments of $830,000 per year are
due at the beginning of each of the four years of the lease.
a. Should Wolfson lease the machine or buy it with bank financing?

b. What is the annual lease payment that will make Wolfson indifferent to whether it
leases the machine or purchases it?
6. Lease or Buy High electricity costs have made Farmer Corporation’s chicken-
plucking machine economically worthless. Only two machines are available to replace
it. The International Plucking Machine (IPM) model is available only on a lease basis.
The lease payments will be $80,000 for five years, due at the beginning of each year.
This machine will save Farmer $29,000 per year through reductions in electricity
costs. As an alternative, Farmer can purchase a more energy-efficient machine from
Basic Machine Corporation (BMC) for $365,000. This machine will save $32,000 per
year in electricity costs. A local bank has offered to finance the machine with a
$365,000 loan. The interest rate on the loan will be 10 percent on the remaining
balance and will require five annual principal payments of $73,000. Farmer has a
target debt-to-asset ratio of 67 percent. Farmer is in the 34 percent tax bracket. After
five years, both machines will be worthless. The machines will be depreciated on a
straight-line basis. Should Farmer lease the IPM machine or purchase the more
efficient BMC machine?

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Chapter 21

1. Off–Balance Sheet Financing What is meant by the term off–balance sheet

a. What is Quartz’s reservation price?

a. Should Wolfson lease the machine or buy it with bank financing?

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