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Sample/practice exam 9 April 2017, questions and answers

Business Finance (University of Nottingham)

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ch17
Student: ___________________________________________________________________________

1. Which of the following statements is not true of a financial lease?

A. It can be cancelled after the equipment is no longer needed
B. It is a source of financing
C. It is binding obligation for the lessee
D. It lessee has the asset for most of its economic life
2. In a net lease:
A. The lessee pays for insurance, but does not maintain the asset
B. The lessee pays to maintain, insure, and meet property tax obligations on the asset
C. The lessor pays for insurance, maintenance, and property taxes
D. The lessor and lessee split the maintenance, insurance, and property taxes 50:50
3. In a direct lease arrangement:
A. The lessee selects the equipment and has the lessor buy it for lease
B. The lessor buys the equipment, then looks for a lessee
C. The lessee buys the asset, then arranges to sell it to lease it back
D. The lessee owns the asset through a holding company
4. A leveraged lease requires a situation where:
A. Lessee loaning part of the asset purchase to the lessor
B. Lessor selling ownership of the leased asset to others
C. Lessor borrows part of the asset's price
D. Lessor loans the lessee funds to maintain the asset
5. A financial lease is also called a full-payout lease because:
A. Lessee agrees to pay the full amount of the lease up front
B. Lessor agrees to pay out the lease if the lessee defaults
C. Lessee pays for full cost of the asset in present value terms
D. Payout of the lease is guaranteed by insurance
6. Sale and lease-back leases involve:
A. Real estate transactions only, where lessee and lessor swap land
B. Situations where the user sells his property and leases it back
C. Transactions where the land is sold to the lessee at the end of the lease
D. Land ownership transfers part way through a lease agreement
7. Financial leases are a source of financing in the sense that:
A. The lessor must find a source of financing to buy the asset
B. The lessee must borrow money for his first lease payment
C. The lessee avoids buying, but gets the use of the asset through financing
D. The lessor can use the lease payments as collateral to borrow
8. An operating lease is cancelable because:
A. The asset is easily broken or damaged
B. The lessee typically is uncertain about his use needs for the asset
C. The lessor may need the asset for some other purpose
D. The lessee is not a good credit risk
9. Which one of the following is a valid statement about leasing in Canada?
A. Less than 5% of machinery and equipment in Canada is leased
B. Lessors prefer to keep equipment at the end of a lease in order to lease it again
C. Lessees typically purchase the asset at the end of the lease
D. Operating leases are particularly useful in the long term

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10. Equipment manufacturers lease out equipment because:

A. They can make more money renting out than manufacturing
B. Leases provide cheap access for small business
C. Laws require equipment makers to lease it
D. Leasing agreements help support and expand sales
11. Short-term leases are convenient but:
A. Often expensive for the lessee
B. Often cheap for the lessee
C. Usually involve second-rate equipment
D. Are not as profitable for the lessor as longer-term ones
12. Some assets are almost impossible to lease short-term because:
A. They are too expensive
B. The assets are hard to transport for use
C. The lessees don't want pay enough
D. The assets to be leased are too susceptible to damage and abuse
13. Lease standardization helps justify leasing because:
A. It makes all lessors pay the same lease payments
B. It lowers costs through standardized leased asset and security evaluations
C. It makes it possible for lessors to investigate lessees more thoroughly
D. It helps lessees to select similar assets
14. A lessor finds a lease attractive from a tax viewpoint because he:
A. Need not pay taxes on his assets so long as they are leased out
B. Gets a tax deduction from his lease payment
C. Can use the lease payment to lower his taxable income
D. Can use the capital cost allowance tax shield from ownership
15. Financial leasing is only justified by one of the following arguments.
A. The lessor can make better use of CCA tax shields than can a lessee
B. Leasing allows financial officers to more easily hide capital expenditures
C. Leasing allows one to get access to an asset with no money down
D. Such leases need not appear on the balance sheet as capitalized items
16. If a lease is capitalized, it has one of the following attributes
A. It shows up as a liability on the lessor's financial statements
B. It is debt on the right-hand side of the lessee's balance sheet, and an asset on the left
C. The lease's present value shows as a liability on the lessee's balance sheet, but not an asset
D. The lease becomes a capital asset for the lessor, allowing him to capitalize on its value to borrow more
17. The lessee in a financial lease bears the most of the same risks and rewards as ownership except:
A. He doesn't know how large his lease payments are
B. He has no tax shelter for his cash outflows
C. He has no access to capital gain from an extraordinary salvage value
D. He can cancel his obligations to a lessor with 30 days' notice
18. Which one of the following conditions is not a single requirement for verifying a financial lease
according to Canadian accounting standards?
A. There is reasonable assurance of asset title transfer at the end of the lease
B. The lessee will receive all or most of the asset's economic benefits
C. The lessor is guaranteed a profit on the lease equal to that of other investments
D. The lessor recovers the fair market value of the asset at the time of signing the lease, plus a return on
that investment

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19. Off-balance sheet financing implies that:

A. Leases would be capitalized
B. Leases would not be capitalized in financial statements
C. Leases would be amortized in a separate account not in the lessee's balance sheet
D. Leases show up in the income statement, but not the balance sheet
20. Debt-rating agencies take financial and operating leases into account because:
A. They realize that lessees need that information for their records
B. The agencies are required by law to do so
C. The book income of the lessee is improved by including lease obligations
D. The book income will be lower, all things equal, if lease obligations show as a balance sheet item
21. If the present value of financial lease payments were $100,000, this capitalized amount would appear:
A. As a liability on the lessee's balance sheet
B. As income on the lessor's income statement
C. As a liability and as an asset on the lessee's balance sheet
D. Only on the lessor's financial records
22. Lease capitalization's value determination requires one of the following methods.
A. Finding the net present value of future lease payments
B. Recording the asset's purchase price as the lessee's asset
C. The lessor shows the asset's effect on his leverage
D. Altering the lessee's restrictive covenants by the amount of the asset's value
23. If a machine costs $50,000, and $5,000 a year for the lessor to maintain and insure, what equivalent
annual cost would serve as the basis of a full-service lease payment for a six-year operating lease, paid in
arrears, if the lessor's cost of capital is 8%?
A. $15,816
B. $73,114
C. $17,155
D. $55,000
24. If the lease payment for the machine in Question 53 were made in advance, starting at the beginning of
the first year of the contract, what would the size of such a payment now be as an equivalent annual cost?

A. $71,455
B. $14,644
C. $15,533
D. $15,816
25. Which of the following is not a normally attractive feature of an operating lease?
A. The lessee has the option to cancel
B. The lessee only needs the equipment for a short time
C. The lessee can't afford to buy the asset
D. The lessor offers superior and cheaper maintenance than the lessee can perform
26. Which one of the following characteristics does not distinguish financial leases from operating leases?

A. Financial lease analysis compares leasing to borrowing

B. Financial leases are not cancelable
C. Operating leases involve real physical assets
D. Operating leases do not extend over the economic life of the asset
27. If a lessor paid $800,000 for an asset, how would the lessee treat this amount in his financial lease
analysis?
A. Lessor would ignore it, since it is a lessor cost
B. Lessor would treat it as a cash inflow, since he avoids it by leasing
C. Lessor would amortize it over the lease life as an expense
D. Lessor would discount it by his cost of capital

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28. If the asset described in Question 57 had a CCA rate of 30%, with the usual half-year rule, and were
leased for 5 years, how would the lessee treat the five years of CCA? The lessee tax rate is 40%. The
asset class uses declining balance.
A Lessee would calculate the CCA amounts for each of the five years, apply the tax rate against these
. amounts, and show these amounts as cash outflows
B. Lessee would calculate the CCA amounts for the entire life of the asset, and show those amounts as
cash flows
C. Lessee would ignore the CCA, since it is the lessor's financial province
D. Lessee would treat the CCA calculations for each of the five years of the lease as cash inflows for the
lessor
29. Which one of the following is not a cash flow item in financial lease analysis?
A. The lessor's repayment schedule for financing the asset
B. The value of the salvage to the lessor
C. The CCA tax shelters of the lessor
D. The lease payment's tax shelter impacts for the lessee
30. What would the CCA tax shields be for Years 0 and 4, assuming these tax shields start in Year 0 and end
in Year 4? Remember: CCA = 30%.
A. $48,000 and $27,989
B. $52,000 and $0
C. $120,000 and $69,972
D. $48,000 and $69,972
31. If the lease payments of the $800,000 asset described in Question 57 were $210,000, first payment
occurring at the beginning of the first year when the lease is signed, how would the lessee treat these
payments in his financial lease analysis? His tax rate is 40%.
A. Lessee would treat each $210,000 payment as a cash outflow
B. Lessee would deduct these $210,000 payments from his CCA
C. Lessee would record net cash outflows for five years of $126,000 for leasing
D. Lessee would amortize the $800,000 over five years and show these inflows
32. What is the undepreciated capital cost of Question 57's $800,000 asset after five CCA calculations of
30% declining balance, with the half-year rule?
A. $0
B. $240,000
C. $163,268
D. $145,564
33. If in financial lease analysis an asset's undepreciated capital cost were $200,000 and its salvage or scrap
value were zero, how would the lessor treat this situation if it were assumed the asset would be alone in
its class if it were owned? The tax rate is 40%.
A. Lessor would ignore this, since this is the lessor's business
B. Lessor would record this as an $80,000 lost tax shield at the end of the lease life
C. Lessor would record the $200,000 as a cost of leasing at the end of the lease
D. Lessor would record the $200,000 as a cost the beginning of the lease
34. Following the time sequence described in Table 22.1, and using the information from Questions 57
through 63, what would the present value of cash flows be for leasing this $800,000 asset if the lessee's
before tax cost of capital were 15%? Note that the asset is scrapped and alone in its pool at the time of
disposition.
A. ($24,555)
B. $3,456
C. $2,457
D. $1,743

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35. If the asset in Question 64 were exactly equal to its undepreciated capital cost instead of zero, what effect
would this change have on the financial lease analysis?
A. The salvage would become a benefit of leasing
B. The change would have no effect on the lease analysis
C. The terminal loss would disappear and that would be the only change
D. The terminal loss would disappear and the salvage is now a leasing cost
36. Even with lease capitalization, the financial positions of lessors and lessees differ. Which of the following
statements does not support that assertion?
A. The asset choice is influenced by the method of financing
B. Secured creditors are more exposed to risk in the lease than are lessees
C. In the face of default, the lessor's exposure to loss is larger than the lessee's
D. The lessor stands to profit from unexpectedly high salvage proceeds, while the lessee does not
37. Because salvage value is a more risky estimate than others in lease analysis, one might do one of the
following:
A. Ignore salvage in one's calculations
B. Use a higher, risk-adjusted discount rate for salvage value estimates
C. Reduce the salvage value by half to account for risk
D. Arrange to sell the asset ahead of time
38. Canada Customs and Revenue Agency is suspicious of financial leases that exhibit the following non-
lease characteristic:
A. The term is very long
B. There is a down payment
C. Lease payments change in size over the lease term
D. The lease allows the asset's title to pass to the lessee without significant cost at the lease's end
39. In the event of lessee bankruptcy, the lessor's legal position with the leased asset is this:
A. The lessor will be first in line as a creditor to recoup the lease's balance
B. The lessor can take back the leased asset, but with no salvage guarantees
C. The lessor has no recourse at all
D. The lessee will ordinarily pay out the remainder of his lease obligations
40. In the event of a lessor's bankruptcy, the lessor's legal position with the leased asset is this.
A. The lessor is obligated to a secured creditor for the full original value of the loan associated with the
leased asset
B. The lessor owes only the amount associated with the remainder of the asset's lease
C. The lessee can force the lessor to provide another asset
D. The lessor has no obligations to creditors, since his asset is leased
41. In financial lease analysis, there is a comparison between:
A. Leasing costs, and owning costs and tax shield benefits foregone
B. The differing lives of a leased and owned asset
C. Various salvage scenarios
D. Economic benefits of owning or leasing one asset or another
42. The appropriate discount rate for financial lease analysis is:
A. The after-tax cost of equity
B. The lessee's weighted average cost of capital
C. The lessor's required rate of return
D. The lessee's after-tax cost of secured debt

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43. As a practical matter, the lessee uses a single discount rate for lease analysis, but a more refined approach
would do which of the following?
A. Use a different discount rate for every line on the lease analysis' cash flows, and so reflect differing
risk for each cash item
B.Use a zero discount rate for the lease payment, a high rate only for the CCA tax benefits, and a middle
rate for the other cash flows
C. Use one discount rate for the lease tax shelter, and another for the other cash flows
D. Use a low, middle, and high discount rate and pick the average result
44. If a financial lease analysis shows a NPV of $1,750 that means:
A. It will cost the lessee $1,750 more to lease
B. It will cost the lessee $1,750 more to own
C. The lessee will have to put down $1,750 as a lease deposit
D. The lessor should raise his annual lease payments by $1,750
45. If a financial lease analysis uses a higher discount rate than a lessee would ordinarily use on conventional
secured loan, which one of the following reasons would best explain that dichotomy?
A. The lessor charges a higher interest rate on the lease than normally
B. The asset is unreliable, so requires a higher discount rate
C. The lessee may be unsure that he can earn enough taxable income to use the tax shields in the lease
analysis
D. The discount rate is uncertain, so a higher one is used
46. If an equivalent loan has the same cash flows as a lease, and results in a $1,500 higher present value, one
could conclude that: present value than the lease analysis indicated, this shows:
A. That leasing is preferable to buying the asset, since owning costs $1,500 more
B. That either is acceptable, since the cash flows are the same
C. One should not lease
D. That owning will require more capital up front
47. If a lease analysis shows exactly the same present value as an equivalent loan, the lessee should:
A. Choose to lease or buy based on other criteria
B. Lease, since there are more tax shelters
C. Buy, because the salvage might be bigger than estimated
D. Neither lease nor buy, since the asset choice is clearly wrong
48. If a financial lease analysis shows a positive result, which one of the following is true?
A. The user should own the asset
B. The lessor should own the asset
C. Given the asset choice, the lease terms favour leasing
D. Leasing is preferable so long as there is no salvage
49. If a financial analysis of a lease shows a negative result of $500, a manufacturer could alter the lease
terms to make leasing profitable by:
A. Cutting his price to the lessor by more than $500
B. Raising the CCA rate for the lessor
C. Raising salvage value by lowering the discount rate
D. Raising the lease terms
50. If a leased asset has maintenance offered as an included extra, such an extra would be evaluated
differently from other leasing cash flows in this way.
A. Maintenance would be estimated over shorter time intervals than the lease
B. Maintenance would represent an extra cost to the lessee
C. Maintenance would be discounted at a higher discount rate to reflect risk, and represent a cash inflow
for lessee
D. Maintenance would all be paid up front

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51. If an asset has a positive salvage of $1,000, exactly equal to UCC, then the lease analysis for an asset
alone in its pool will show the following cash flows for that phenomenon.
A. The salvage is a cost to leasing; there is no terminal loss or gain
B. The salvage is a cost of owning, the terminal loss is $1,000
C. Salvage has no effect on leasing, since it belongs to the owner
D. The tax shelter for the terminal gain will be $1,000
52. If an asset has a positive salvage of $1,000, exactly equal to UCC, then the lease analysis for an asset
alone in its pool will show the following cash flows for that phenomenon.
If the asset described above were not alone in its pool, so the pool continued after the leased asset is
disposed of, the following would be true.
A. The tax shelter would now be larger by $400
B. The tax shelter implications would be the same as in Question 84
C. The tax shelter from the asset disposition would be delayed until the pool is terminated
D. The salvage would be a cost of leasing, minus the lost tax shelter
53. If a leased asset were scrapped from a continuing CCA pool after four years, and its UCC were $10,000
and its salvage is zero, what would the present value of this asset's tax shelter be if the appropriate after-
tax borrowing rate is 9%, the CCA rate is 20%, and the tax rate is 40%?
A. -$2,759
B. -$1,955
C. +$10,000
D. +$2,759
54. The most important issue that makes it possible for both a lessor and lessee to gain from a financial lease
arrangement is (aside from risk):
A. The lessee's better cash flow
B. The lessor's purchasing power for leased assets
C. The lessee's higher marginal tax rate
D. The lessor's higher marginal tax rate
55. Governments "incur losses" on good leases in the sense that:
A. Well-constructed leases defer taxes
B. The best leases take maximum advantage of lessor-lessee tax differentials
C. The government finds itself helping finance leases that fail because of lessor insolvency
D. The CCA rates are lower for some assets more than others
56. If the tax rates of the lessor and lessee are the same, then the financial lease analysis that shows a $500
positive NPV will suggest that:
A. The lessor is $500 better off than the lessee
B. The user should lease, not buy
C. The lessor should lower his lease terms
D. The user should buy, not lease
57. The best situation to encourage leasing would be one in which:
A. The lease payments are larger in the early part of a short contract
B. The interest rate is low
C. The lessee's tax rate is lower than the lessor's
D. The CCA tax shield occurs late in the lease period

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58. Which of the following are specific tests that the Canada Revenue Agency will apply to determine if a
particular lease meets the definition of a capital lease?
1. The lease term is equal to 75% or more of the economic life of the leased property.
2. The present value of the minimum lease payments is equal to 70% or more of the fair value of the
leased property at the inception of the lease.
3. Provisions are made such that ownership of the leased property is transferred to the lessee at the end of
the lease term.
A. 1 only
B. 1 and 2
C. 1 and 3
D. 2 and 3
59. Which of the following is not a reason for leasing?
A. Leasing provides the lessor with insurance against obsolescence
B. Leasing can reduce taxable income
C. Leasing can be a source of off-balance-sheet financing, provided certain conditions are met
D. A company can obtain financing easier by the leasing company retaining title to the asset
60. All but one of the following are reasons for leasing:
A. Companies with a weak credit rating can obtain financing because the lessor retains title to the asset.
B. Payments on a lease are variable, and therefore removes an additional element of uncertainty.
C. The terms offered under a lease may be more attractive than those that a customer could get under a
comparable loan.
D. Leases provide the lessee with flexibility and insurance against obsolescence.
61. Which of the following is not required to calculate the NPV of a lease?
A. Present value of the net benefit that comes from the residual value lost because of leasing
B. Original purchase price of the asset
C. Present value of CCA lost
D. Present value of before-tax lease payments
62. All of the following must be included on a company's balance sheet except:
A. Capital leases
B. Sale and leaseback agreements
C. Operating leases
D. Leveraged leases
63. Which rate should you use to discount the leasing cash flows in an NPV analysis?
A. WACC
B. Market interest rate
C. Cost of debt
D. Internal rate of return
64. When deciding whether or not to lease an asset, the _____________ should be compared against the
______________, and if the first is lower then the company should proceed with the lease.
A. Internal rate of return/cost of debt
B. WACC/cost of debt
C. Cost of debt/internal rate of return
D. Return on equity/WACC
65. You are the CFO of a company. You are considering leasing photocopiers from the manufacturer instead
of purchasing them for $200,000. You can borrow at 9% and the corporate tax rate is 35%. The lease
payment will be $50,000 for five years. At the end of the five years, the photocopiers will be worthless.
Photocopiers are depreciated at 20% CCA rate. What is the NPV of the lease?
A. $27,304
B. $39,582
C. $52,395
D. $73,586

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66. You are the manager of a sales division. You are considering leasing a fleet of cars for your staff. You
can buy the cars for $300,000 or you can lease them for eight years at $60,000 per year. The company
faces a tax rate of 40% and a CCA rate of 10% on vehicles. If the company buys the cars and finances
the purchase with a loan, they will pay 7% in interest. Assume that after the term of the lease is over, the
salvage value of the cars will be zero. What is the NPV of the lease?
A. $9,340
B. $16,754
C. $29,521
D. 34,195
67. CumChan is a financial services firm. They need computer equipment and have decided to lease the
equipment with an operating lease. They want to prevent additional debt from showing up on their
balance sheet. Which of the following must be true about their lease for this to work?
A. The lease term is equal to 65% or more of the economic life of the leased property
B The present value of the minimum lease payments is equal to 75% or more of the fair value of the
. leased property at the inception of the lease
C The present value of the minimum lease payments is equal to 90% or more of the fair value of the
. leased property at the inception of the lease
D. The lease term is equal to 90% or more of the economic life of the leased property
68. Leasing is a financial arrangement between a lessor, or owner, and a lessee or user of an asset.
True False
69. When a lease is terminated, the equipment always reverts to the lessor.
True False
70. An operating lease is a longer term arrangement than a financial lease.
True False
71. In a financial lease, the lessee can always cancel his lease without penalty.
True False
72. A sale and leaseback arrangement transfers ownership from a user to a lessor who then leases the asset
back to the former owner.
True False
73. Leasing in Canada is growing less significant as interest rates fall.
True False
74. A sensible, not dubious, reason for a lease would revolve around preserving capital through leasing rather
than putting up the full price through owning.
True False
75. Lessors specializing in financial leases often have off-lease assets for sale, since this helps their business
marketing.
True False
76. It is difficult to rent fragile equipment in short-term operating leases.
True False
77. Leasing allows small lessors to "lend" cheaply because lease contracts and collateral come in
standardized forms.
True False
78. If one capitalizes a lease, off-balance-sheet financing is not possible.
True False
79. When one capitalizes a lease, one finds the nominal total of all future lease payments and records them as
a liability on right hand side of the balance sheet.
True False

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80. In an operating lease, the lessor bears more ownership risk than a lessor in a financial lease would.
True False
81. If a lease is capitalized, the firm successfully circumvents restrictive financing covenants.
True False
82. A capitalized lease affects financial leverage and rate of return calculations.
True False
83. Generally, equivalent annual cost analyses show that the longer you need an asset, the more likely it is
that it is cheaper to buy rather than lease an asset.
True False
84. Financial leases cover the entire economic life of the asset and are not cancellable.
True False
85. Cash-flow analysis of a financial lease counts capital cost allowances from owning as savings for a
lessee.
True False
86. The salvage value of a leased asset affects the cost of the lease through the tax shields associated with
owning.
True False
87. Lease payments have no tax shelter effects; only CCA's associated with owning.
True False
88. A lessor and lessee have the same exposure to financial risk.
True False
89. The before-tax cost of risk-free debt is the appropriate discount rate for net present value analysis of lease
costs.
True False
90. An equivalent loan analysis of a lease payment finds the loan amount that is equal to the present value of
the after-tax lease payments, discounted with the firm's after-tax cost of capital.
True False
91. If your equivalent loan analysis of a lease shows a higher immediate cash flow for the borrowing plan,
based on the same cash flows as the lease, then one should not lease.
True False
92. Lease financing analysis concentrates not only on the net difference between leasing and borrowing and
then buying, but also examines the various alternative assets that would be considered for leasing or
buying.
True False
93. Lease analysis reveals that salvage value of an owned asset has a significant effect on the incremental
analysis of a lease.
True False
94. Since salvage is more risky than other lease analysis cash flows, it is logical, though not always practical,
to use a higher discount rate for salvage in present value calculations in such analysis.
True False
95. If an asset had a $20,000 salvage value at the end of the lease and the asset is sold, it would make no cash
flow difference whether the asset pool were terminated or remained open.
True False

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96. If a lessor has a tax bracket much higher than a lessee's, and the CCA tax shields occur early in the lease,
there is little incentive for a lessor and lessee to construct a lease to their mutual after-tax benefit.
True False
97. If a lessee has a zero tax rate, he faces no advantage of leasing over buying, since he gets no tax shelter in
either case.
True False
98. Describe three major differences between operating and financial leases, pointing out how these
differences reflect varying lessor and lessee situations.

99. Provide a critique of two weak or dubious reasons for leasing.

100.A financial lease has the following characteristics: Asset cost: $10,000; tax rate: 30%; CCA rate: 20%;
after-tax cost of capital: 15%, lease term: 4 years, with $2,500 annual lease payments and tax shields in
advance, and salvage and UCC tax shields in Year 4. Salvage is zero. The asset is part of a large pool.
What important timing considerations should an analyst watch for in this analysis? What is its present
value?

101.An equivalent loan helps one think about the results associated with financial lease analysis where the
viewpoint is from a lessee's perspective, net of the lessor's position. Explain how this is true, and the
equivalent loan concept's usefulness in lease analysis.

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102.Salvage deserves special consideration in financial lease analysis, just as it does in any capital budgeting
situation. Explain how this is true, both in terms of salvage estimates, and in the treatment of salvage and
UCC tax shields.

103.Lease analysis is affected by assumptions about the asset pool in which the leased asset is kept. Explain
how the results of such analysis would be different if the asset was alone or if many assets in it pool at
the end of a lease contract. Consider the situation where the tax rate is 40%, CCA = 30% and the discount
rate were 10%, and the difference between UCC and salvage were $10,000.

104.Maintenance costs can make the lease analysis a complicated affair. Explain how maintenance affects
financial lease calculations.

105.A lessor and lessee are most able to maximize their financial communities of interest through a lease
contract if the lessor's tax rate is very high and the lessee's very low. Explain how this would be true, and
the implications for the type of firms who lease their assets and the type of companies who operate as
lessors.

106.Describe how risk plays a role in financial lease analysis, particularly in discount rates, salvage values,
maintenance costs and insolvency circumstances.

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107.Why calculate a lease versus buy decision from the perspective of the lessee? Why not instead find
the present value cost of owning, and then find the present value cost of leasing, and compare which is
cheaper?

108.Ajax Company is considering a three year financial lease. A cash flow schedule was developed that
reflects the cost of the machine, CCA tax shields and after tax lease payments. The company has a 10%
rate requirement and a 30% tax rate.

What is the value of the lease?

109.Nantec Company is considering a three year financial lease. A cash flow schedule was developed that
reflects the cost of the machine, CCA tax shields and after tax lease payments. The company has a 12%
return requirement and a 40% tax rate.

What is the value of the lease?

110.110.Globetech is considering leasing a $75,000 equipment. Five annual payments of $15,000 are due
in advance. Globetech's required rate of return is 9% and has a 35% tax rate. The asset is in the 25%
CCA class. The half year rule applies and CCA is taken in year 0. After the fifth year, the asset becomes
worthless. Determine the NPV of the lease.

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111.Ajax is considering leasing a $900,000 equipment. Five annual payments of $190,000 are due in advance.
Ajax's required rate of return is 12% and has a 35% tax rate. The asset is in the 25% CCA class. The half
year rule applies and CCA is taken in year 0. After the fifth year, the asset becomes worthless. Determine
the NPV of the lease.

112.112.Simpson is considering leasing a $500,000 equipment. Four annual payments of $150,000 are
required at the end of each year. Simpson's required rate of return is 6% and has a 40% tax rate. The asset
is in the 25% CCA class. The half year rule applies and CCA is taken in year 0. After the fourth year, the
asset becomes worthless. Determine the NPV of the lease.

113.Four annual payments of $20,000 are required at the end of each year. Donny's required rate of return is
11% and has a 40% tax rate. The asset is in the 30% CCA class. The half year rule applies and CCA is
taken in year 0. After the fourth year, the asset becomes worthless. Determine the NPV of the lease.

114.Global Inc. is considering leasing a $45,000 equipment. Four annual payments of $15,000 at the end of
each year. Global Inc.'s required rate of return is 13% and has a 30% tax rate. The asset is in the 25%
CCA class. The half year rule applies and CCA is taken in year 0. After the fourth year, the asset becomes
worthless. Determine the CCA tax shields for this lease.

115.115.Calculate the net cash flow of lease, given lease payments of $10,500; lease payment tax benefits of
$4,150; and CCA tax shield of $2,200

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ch17 Key
1. A

2. B

3. A

4. C

5. B

6. B

7. C

8. B

9. C

10. D

11. A

12. D

13. B

14. D

15. A

16. B

17. C

18. C

19. B

20. D

21. C

22. A

23. A

24. B

25. C

26. C

27. B

28. A

29. A

30. A

31. C

32. C

33. B

34. D

35. D

36. A

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37. B

38. D

39. B

40. B

41. A

42. D

43. A

44. B

45. C

46. C

47. A

48. C

49. A

50. C

51. A

52. B

53. B

54. D

55. B

56. A

57. C

58. C

59. A

60. B

61. D

62. C

63. D

64. A

65. A

66. B

67. C

68. TRUE

69. TRUE

70. FALSE

71. FALSE

72. TRUE

73. FALSE

74. FALSE

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75. FALSE

76. TRUE

77. TRUE

78. TRUE

79. FALSE

80. TRUE

81. FALSE

82. TRUE

83. TRUE

84. TRUE

85. FALSE

86. TRUE

87. FALSE

88. FALSE

89. FALSE

90. TRUE

91. TRUE

92. FALSE

93. TRUE

94. TRUE

95. FALSE

96. FALSE

97. FALSE

98. Operating leases are shorter term, do not fully repay the lessor for the purchase price with the first lease, and are often cancellable, qualities
usually absent with financial or long-term leases. Financial leases are usually for new assets, while operating leases typically represent a string of
leases on the same asset. Financial lease varieties include leveraged leases, wherein the lessor borrows part of the purchase price of the asset, using
the asset as security. In financial leasing, the lessee often plays an important if not dominant role in choosing the asset for purchase by the lessor,
since its use and economic life is centered on the single lessee's requirements. Operating leases tend to work best for equipment that has a short
economic or technological life, and for lessees with limited use time horizons.

99. Leasing to avoid capital expenditure controls or to preserve capital makes no financial sense, though it may have political or public relations
appeal. The obligations of a financial lease represent another form of financing, which, if capitalized, has the same effect as owning, save for
issues of salvage risk and differential tax shelter implications. Generally though, leasing to avoid "putting up the money to buy" makes no sense,
since one could 100% finance an asset through purchase, equivalent to borrowing through a lease. While leasing may appeal because it masks
obligations to the unsophisticated, it makes no sense. A second weak argument would revolve around failure to capitalize or display on financial
statements the obligations of a financial lease. Canadian and U.S. accounting standards demand such a practice, so to use the failure to do so as a
reason to lease appears irrational.

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So timing affects the analysis, though in this case it doesn't change the pro-lease result.
NPV @ 15%: $2,330

… with lagged tax shields …

NPV @ 15% = $2,479

100. Timing is important in laying out this analysis. In the text, the pattern has been to assume the lease payments and tax shields occur in
advance, and the salvage and UCC tax shields occur one period after the last lease payment. Such timing may not hold in all circumstances. For
example, the lease payments may start in Year 0, but the tax shields occur one period later. By the same logic, the CCA tax shields may also start
in Year 1, not Year 0. This will affect the present values. In a similar vein, the salvage may occur now in the same time frame as the last CCA
tax shelter and lease payment shield. So timing will affect the lease analysis. For example, if the tax shelter patterns follow that of Table 22.1, the
NPV of this lease is $2,479; if the tax shelters are lagged one year as described above, the NPV is $2,330. The numbers look like this:

101. An equivalent loan comes from a calculation that discounts the lease cash outflows associated with a lease versus buy analysis, and compares
the result with the inflows at the beginning of the lease payments at Year 0. The flows are after-tax flows that take into account the lease versus
buy alternative, and so the calculations show how the cash outflows can be seen from another perspective. If these outflows so discounted result in
a larger number than the lease net inflows in Year 0, one should reject leasing and buy instead. The approach illustrates that if one could devise a
borrowing plan for an asset that had the same cash flow as a lease, but a higher present value or immediate cash flow, owning would be preferable.
This result also helps explain why a negative result for a lease analysis is a recommendation to buy, since the difference between the equivalent
loan's discounted cash flows and the lease's Year 0 cash flow represents the difference in favour of buying.

102. If salvage is not zero, the present value of the salvage adds to the cost of leasing. In this case, with declining balance depreciation and
pooling, there is a necessary reconciliation of UCC and salvage. That difference will generate a positive or negative UCC tax shield reconciliation,
to be discounted from the end of the lease back to Year 0, and to be counted as a cost or benefit of owning, and thence in reverse sign to leasing. If
salvage and UCC are exactly the same, there is no UCC tax shield reconciliation. All this becomes further complicated by pool closing issues: if
the asset closes out the pool at its disposition at the end of the lease, the terminal gain or loss caused by a UCC versus salvage anomaly is simply
attributed to income in that year. Since salvage estimates are often the most difficult to make, often a higher discount rate is used for the salvage
estimates (but not the UCC tax shields) in order to account for that risk.

103. If the asset were alone, upon disposition it would generate a terminal gain if salvage is greater than UCC, and a terminal loss if salvage is
less than UCC. If salvage is exactly equal to the proceeds of disposition, there is no gain or loss. Canada Customs and Revenue will treat the
terminal loss as credit against taxes payable, worth in cash terms (1 -T) times this amount as a cash flow tax shield. In contrast, a terminal gain
will be included in taxable income, whose proceeds are (1-T) times the gain. If the asset so disposed of is from a continuing pool, and it generates
values for salvage different from UCC, then the difference is a tax credit or tax cost as before, but its amount is now more complicated to calculate,
looking like this: (T)(D) (S-UCC)/k + D, where the difference between S and UCC is found as a present value of an infinite series at the end of
the lease, subsequently discounted from the end of the lease period back to zero for NPV calculations. Clearly asset pool issues will influence the
value of this UCC tax shield reconciliation, given identical salvage and UCC values. In numbers used in the question, the tax impact of the closed
pool asset would be $4,000 cost or credit [(10,000)(0.4)] depending whether is a gain or loss; in the open pool instance, the cost or credit would be
$3,000 [(10,000)(0.4)(0.3)/(0.10) + (0.30)].

104. Since maintenance is harder to predict than many cash flows, it might appropriately face a higher discount rate than other such flows, much as
one could treat the similarly risky salvage values. Maintenance is also a consideration in lease agreements, sometimes included and paid for by the
lessor, sometimes not: in a full-service lease, the lessor pays maintenance; in a net lease, the lessee pays the maintenance among other items such
as insurance and property taxes. Financial leases are typically net leases. However, since the lessor ultimately will get the property back, he retains
an interest in the quality and cost of such maintenance, even if he expects the lessee to eventually buy the asset from him at the end of the lease.
Generally then, maintenance uncertainty makes the cost of leasing higher.

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105. If a lease analysis shows a positive NPV to leasing, and both lessee and lessor have the same tax rates, then the positive result to lessee is
a negative result for the lessor, since the analysis looks through the lessee's eyes. So if one reversed the signs of the cash flows in that tax-rate-
identical analysis, the result would negative for the lessor. However, if the tax rates for the lessor and lessee are not identical, then the lessor and
lessee could both gain from the lease agreement. This comes about because a higher tax rate for the lessor allows the CCA interest tax shields to
carry more cash flow, while the lower tax rate of the lessee makes these tax shields less attractive to the lessee

106. Risk pervades lease analysis because of the universal issue of estimation imprecision. In lease analysis, one sees how the discount rates used
count well change with such risk: maintenance and salvage are often troublesome guesses. In the same vein, if a lessee goes bankrupt, the lessor
can reclaim the asset, but he may find it worth considerably less (or more) than the present value of the remaining lease payments. So the lessor's
risk is greater than the lessee's, given the lessee's insolvency. Put another way, the lessor has limited recourse in this instance, since his access to
the lessee's assets are typically in a secondary position to other creditors'. While tax shields figure prominently in the lease analysis, they too bear
risk, since their cash flows in the analysis are based on marginal tax rates that in fact the lessee will not face, since his taxable income may be
lower than expected. Clearly changing the tax rate and the shields associated with it could well change the outcome of lease analysis, as can these
other risky inflows and outflows in lease analysis.

107. The lease versus buy analysis is inherent in the lease analysis approach, and allows one to make a single round of calculations to reach a
point in the calculations where the decision to lease or not is accepted or rejected by the numbers themselves. Treating the ownership costs as
lessee benefits and ownership benefits as lessee costs depicts directly the issue at the heart of the analysis, keeping the comparison of one form
of financing (buying or leasing) at the forefront of the deliberations. When one considers the idea of divergent tax rates for lessors and lessees,
and particularly a situation where the lessee tax rate is lower, clearly the "net" approach comes apart to some extent, since one must examine
the owner's and lessee's cash flows separately. However, even here, it is important to note how the analysis still returns to the net position of the
lessee.

= 62,000 - 58,803.91 = $3,196.09. The lease will add positively to the value of the purchase.
Value of the lease = NPV of lease = Initial lease cash inflow - equivalent loan

108. The value of the equivalent loan is the present value of the after-tax lease cash outflows, discounted at the after-tax cost of borrowing, (1 - .3)
× .10 = .07, 7%:

Using the BAII Plus calculator:

= 80,000 - 78,442.68 = -$1,557.32. The lease will add negatively to the value of the purchase.
Value of the lease = NPV of lease = Initial lease cash inflow - equivalent loan
109. The value of the equivalent loan is the present value of the after-tax lease cash outflows, discounted at the after-tax cost of borrowing, (1 - .4)
× .12 = .072, 7.2%:

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110.

111.

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112.

113.

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114.

115. $8,550

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ch17 Summary
Category # of Questions
Brealey - Chapter 17 115
Difficulty: Easy 34
Difficulty: Hard 22
Difficulty: Medium 59
Learning Objective: 17.1 50
Learning Objective: 17.2 20
Learning Objective: 17.3 19
Learning Objective: 17.4 26
Type: Multiple Choice 67
Type: Short Answer 18
Type: True False 30

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