7/26/23

Financial Services

MBA-BM
Session 17-19

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• Leasing

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What is leasing ?
• To implement an investment project or to
carry out vital activities related to regular
operations , a firm must acquire the necessary
property ,plant and equipment.

• A firm has the option of

– Purchasing these assets outright
– Leasing them

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What is leasing ?...contd..

• Lease may be defined as a contractual
arrangement in which a party owning an asset
/equipment provides the asset for use to
another party, for an agreed period of time in
return for payment of periodic rentals .

– Because the user also has the option to buy the asset
using own money/borrowed money , hence both
leasing and buying are basically alternative financing
arrangement for the use of an asset.

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Leasing and renting

• These terms are mostly interchangeable, but they
have slight differences.

• "lease" implies a comprehensive written agreement

for the use of property belonging to another. The term
• "rent" is more loose to include any use of another's
property for payment, whether under a formal
agreement or not.
– In other words, when you lease something you are also
renting it, but when you rent something you are not
necessarily leasing it.

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Essential elements in a lease deal

• Underlying asset( property/equipment)

• Lessor – party who actually owns the asset

– The lessor is either the asset’s manufacturer or an
independent leasing company.
– If the lessor is an independent leasing company , it must
buy the asset from a manufacturer and then deliver the
asset to the lessee.

• Lessee--- party to whom the asset is given for use

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Essential elements in a lease

deal..contd…
• Lease rentals--- Consideration/regular/periodic
payments which the lessee pays to the lessor in lieu
of the right to use the asset for its own productive
use.

• Term of the lease--- period for which the agreement

of lease remains in operation.

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Leasing: global scenario

• Equipment leasing is a rapidly growing industry globally.

• 80% of US companies lease all or some of their equipments, and

more than 25% of the world’s aircraft fleet is leased.

• The International Leasing Finance Corporation (ILFC)is the top

aircraft leasing company by fleet size followed by GE Capital
Aviation Services(GECAS).
– They both own hundreds of aircrafts and lease them to major airlines
all over the world.

• for details see :

– http://en.wikipedia.org/wiki/International_Lease_Finance_Corporatio
n

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Indian Scenario
• Total volume stood at around $40 b.
• This is around 4%-5% of the total global volume.
– Considering the size of Indian economy ( 6th largest ?) the size
of the leasing industry is small.
• Roughly the annual leasing volume in India stood around
$3.67 b .
• Popular business models in India :
– Captive leasing and financing arms of leading manufacturers.
– Rental Operators
– Third Party financiers or Non Banking Finance Companies
(NBFCs)
– For more details : see :
– https://www.indiafinancing.com/Indian_Leasing_market_an_ov
erview.pdf

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Types of leases
• Following are some of the major types of leases :
– Based on Extent to which risk and ownership is
transferred
• Operating lease and
• Financial or Capital lease
– based on domiciles of the equipment manufacturer,
the lessor and the lessee etc.
• Domestic and
• International or Cross border lease
– Special types :
• Sale and leaseback and Direct lease
• leveraged lease
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Operating lease
• An operating lease is a short tem lease with the
following important characteristics :
– Usually not fully amortized i.e the lease rentals received
are not enough to recover the full cost of the asset for the
lessor.
– The term or life of the lease is usually much less than the
economic life of the asset.
– The lessor is expected to recover the cost of the asset by
leasing it a number of times or selling it for its residual
value at the end of a contract.
– Usually require the lessor to pay for operating costs,
maintenance and insurance of the asset
– Lessee enjoys a cancellation option before the expiration
date of the lease without significant penalty

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Financial or Capital Lease

• The terms are opposite to that of an
operating lease.
1. Do not require maintenance or service by the lessor.
2. Financial leases are fully amortized.
3. The lessee usually has a right to renew the lease at
expiry.
4. Generally, financial leases cannot be cancelled ( not
without a significant penalty)

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Other Classifications of Lease

• based on domiciles of the equipment
manufacturer, the lessor and the lessee etc.
– Domestic Lease and
– International/Cross border lease
• Other special types :
– Sale and leaseback and Direct lease
– leveraged lease

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Sale and Leaseback

• Owner of an asset sells the equipment to another
party and immediately leases it back from him.
• Two sets of cash flows and two contracts happen( a
sale contract and a lease contract):
– The lessee receives cash today from the sale.
– The lessee agrees to make periodic lease payments, thereby retaining
the use of the asset.

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Benefits of Sale and leaseback ( SLB)

• Liquidity
– while normal lease transactions do not lead to cash in the
hands of the lessee, SLBs do, SLBs extend leasing to a
device of unlocking of investment. The money raised by
SLBs is like general purpose corporate funding – it may be
used for any purpose as the lessee may choose.

• Financial restructuring
– if the money raised by an SLB is used to pay off on-
balance sheet liability, the SLB may have twin effects on
the balance sheet. By putting fixed assets off the books,
it reduces operating leverage, and by reducing liabilities,
it reduces financial leverage.

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Sale and Leaseback…examples

• For example in January 2006, Franklin Electronic Publishers ,
distributor of Rolodex electronic organizers, closed the sale and
leaseback of its corporate headquarters building. The company sold
the building for $10.3 million, and at the same time agreed to a 10-
year lease with the purchaser with an initial annual payment of
$736,000.

• In 2002, San Francisco Municipal Railway used the $35 million in

proceeds from the sale and leaseback of its 118 rail vehicles to
offset a large operating budget deficit. The purchaser CIBC World
Markets of Canada , received a tax benefit from depreciating the
rail cars, something Muni could not do as a public transit agency.

• In India, for example during FY -2007, Jet airways limited sold and
leased back four Boeing 737-700s aircraft.

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Leveraged Leases
• A three-sided arrangement between the lessee,
the lessor, and lenders:
– The lessor owns the asset and for a fee allows the lessee to
use the asset.
– The lessor borrows to partially finance the asset.
– The lenders typically use a nonrecourse loan. This means
that the lessor is not obligated to the lender in case of a
default by the lessee. However the lender is protected in
two ways :
• The lender has the first lien on the asset
• In the event of a loan default , the lease payments are made
directly to the lender

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Leveraged Leases..contd…

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Leveraged Leases…contd..
• The lessor puts up only part of the funds but gets the lease
payments and all the tax benefits of ownership.

• The lease payments are used to pay the debt service of the
non recourse loan.

• The lessee benefits because in a competitive market, the

advantages to the lessor in terms of saving taxes are passed
on to the lessee in terms of lower lease rentals.

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Domestic lease and International Lease

• A lease transaction is classified as domestic, if all the parties
to the agreement, namely, equipment supplier, lessor and the
lessee are all domiciled in the same country.

• International Lease: If the parties to the lease transaction are

domiciled in different countries, it is called an international
lease. International lease can again be :
• Import lease: if lessor and lessee are domiciled in the same
country but the equipment supplier is located in a different
country. The lessor imports the asset and leases it to the lessee.
• Cross Border lease: When the lessor and the lessee are domiciled
in different countries, the lease is called a cross border lease. The
country of the asset supplier is immaterial over here.

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Lease Accounting
• For Operating Lease
• Operating leases are viewed as a rental for
accounting purposes, in which
– the lessee reports the entire lease payment as an
operating expense in the P/L account.
– Neither the asset nor the liability in terms of lease
rentals is reflected in the balance sheet.

– Hence operating lease can effectively lead to “Off

balance Sheet” financing .
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Lease Accounting ..contd…

• The lessee does not deduct a depreciation expense for the asset
and
• does not report the asset or the lease payment liability in its
balance sheet.
– Operating leases are disclosed in the footnotes of the lessee’s
financial statements.

• The tax benefit to the lessee is on the entire lease rental.

• The lessor claims the depreciation tax shield for owing the asset.

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Lease Accounting … contd..

• For Capital Lease/Finance Leases :
• Viewed as an acquisition for accounting
purposes;
– the lessee lists the asset on its balance sheet and
incurs depreciation expenses.
– The lessee also lists the present value of the
future lease payments as a liability.
– The interest portion of the lease payment is
deducted as operating expense from P/L.
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Lease Accounting … impact on balance sheet

and debt ratio

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Lease Accounting … impact on balance sheet

and debt ratio..contd..

Because capital leases increase the apparent leverage of the firm’s balance sheet,
firms sometimes prefer to have operating leases to keep it ‘off’ the balance sheet
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Lease Accounting.. example

• Emerald Inc . Is a moderately sized construction company that operates
in New York. Last year it leased a crane from GD Credit corp. for a term
of 15 years at an annual lease rental of $20,000 payable at the end of
each year. The crane is expected to be completely worn out and
valueless at the end of the lease. Before the lease agreement was made,
other financing sources were willing to lend emerald at 5%. Emerald will
depreciate the crane using SLM over 15-year life . Just before the lease
was signed Emerald’s balance sheet looked as follows :

Emerald balance Sheet ($000)

CA 20 CL 10
FA 180 LTD 90
Total 200 Equity 100
Total 200

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Lease Accounting.. example …. Contd…

• The lease is treated as a financial lease.

• a. Construct Emerald’s balance sheet after the lease is

signed showing the leased asset and lease obligation
separately.

• b. Calculate the firm’s debt ratio before and after the lease
takes effect , and comment on the difference.

• c. Reconstruct the balance sheet after the first annual

lease payment is made assuming all other accounts are
unchanged.

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Lease Accounting.. example …. Contd…

• Solution :
– a. Emerald will capitalize the lease at an amount equal to the PV of the
annuity formed by lease rentals=
PVIFA(5%,15)*20,000=$207,594=$208(000) (approx)
– A) Hence the B/S immediately after the lease is signed as
follows :

Emerald balance Sheet ($000)

CA 20 CL 10
Leased Crane 208 Lease 208
Obligation
FA 180 LTD 90
Total 408 Equity 100
Total 408

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Lease Accounting.. example …. Contd…

• b. Emerald’s debt ratio before the lease is
– (CL+LTD)/Total assets = (10+90)/200=50% ( D/E = 1.0)

• After the lease is signed, the lease obligation is included as debt in

calculating the debt ratio, which increase substantially….
– Debt ratio = (CL + Lease obligation + LTD)/Total assets =
(10+208+90)/408= 308/408=75% ( D/E = 3.08… 3 times that before)

• Comment : The lease creates a major deterioration in Emerald’s

debt ratio that could jeopardize its viability. It would certainly
lessen the firm’s ability to borrow from other sources.

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Lease Accounting.. example …. Contd…

• c. To construct the new B/S, we must first calculate the first
year’s amortization of the leased crane and lease obligation
accounts.
– Each of those is then subtracted from the respective beginning
account balances.
– The asset is simply depreciated while the liability is amortized
as if it was a loan at 5%(cost of a normal loan)

• First consider the asset, the leased crane account.

– First year’s depreciation = 207.594/15=13.840

– So balance amount after first year's depreciation = 207.594-

13.840= 194 ( approx)

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Lease Accounting.. example …. Contd…

• Next consider the lease obligation account.
– Interest in the first year =5%*207.594=10.380.
– Therefore obligation reduction( principal
payment)
– lease payment – interest
– 20-10.380= 9.620.
• First years ending balance after obligation
reduction
– 207.594-9.620=197.974= 198 (approx)

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Lease Accounting.. example …. Contd…

• Finally the B/S after one years payment of lease rentals is as follows :
• Because the leased crane and the lease obligation accounts are
amortized using different methods, there is no reason that their balances
will be equal until the end of the lease when both will be amortized to
zero. In practice what we are showing in the lease balancing account will
fall into equity. The interest portion of the lease payments will be
deducted from P/L a/c.

Emerald balance Sheet ($000)

CA 20 CL 10
Leased Crane 194 Lease Obligation 198

FA 180 LTD 90
Total 394 Lease balancing account (4)

Equity 100
Total 394
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Lease accounting … criteria for consideration as

a capital lease
• It is argued that a firm’s financial strength is inversely related to the
amount of debt in its balance sheet.

• Because the lease liability is hidden with an operating lease , the

balance sheet of a firm with an operating lease looks stronger
than the balance sheet of a firm with an otherwise identical
capital lease.

• Thus given a choice, most firms would probably classify all their
leases as operating leases.

• Because of this tendency, accounting standards today specify that

a lease must be considered as a capital lease, if, at least one of the
following conditions is satisfied.

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Lease accounting … criteria for consideration as a

capital lease …contd….
• i.) The lease transfers ownership of the asset to the lessee by the
end of the lease term OR,

• ii) The lessee has the option to purchase the asset at a price which
is expected to be sufficiently lower than the fair market value at
the date the option becomes exercisable and at the inception of
the lease it is reasonably certain that the option will be exercised
OR,

• iii) The lease term exceeds 75% of the useful life of the asset and

• iv) The present value of the minimum lease rentals exceeds 90% of
the fair market value of the asset at the inception of the lease

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Advantages of leasing
• To The Lessee :
• 1) Flexibility: Equipment leasing is a flexible financing arrangement in the
sense that the lease rentals can be structured in a manner that squares
with the cash flow pattern anticipated by the lessee.

– If the lessee expects a constant cash flow stream from the project in which the
leased assets are employed, the lease rentals can be evenly spread over the
lease term.

– On the other hand if the lessee anticipates a steadily increasing stream of

cash flows, the lease rentals can be stepped up gradually.

– If the lease finance is availed for a project with a gestation period, the lease
rentals can be structured with a deferment period.

• The various ways of structuring lease rentals is explained through the

following example :

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Example
• Sunrise leasing has made available the following data :
• Investment cost = Rs 40 lakhs
• required rate of return = 20% pa
• Primary lease period( during which the lease cannot be cancelled)
= 5 years
• Residual value after primary period = Nil
• It seeks your help in determining the annual lease rentals to be
paid end of the years and charged under the following rental
structures :
– A. Equated
– B . Stepped ( Assume an increase of 15% pa )
– C. ballooned ( Assume an annual rental of Rs. 4 lakhs for years 1
through 4)
– D. Deferred ( Assume a deferment period of 2 years)
• 13.38,10.43,(4,4,4,4,73.77),27.34

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Advantages of leasing …. Contd…

• Flexibility … contd..
• Solution :
• A. Equated
– Denote Y as the annual rental to be charged.
– So , Y x PVIFA(20%,5) =40
– Y = 40/2.991 = Rs. 13.37 lakhs
• B. Stepped ( Assume an increase of 15% pa )
– Let Y be the annual rental in the first year
– Therefore , Y *PVIF(20%,1)
+1.15Y*PVIF(20%,2)+1.152Y*PVIF(20%,3) +1.153Y*PVIF(20%,4)
)+1.154Y*PVIF(20%,5)= 40
– i.e Y=10.43 lakhs
– … so find the lease rentals every year.

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Advantages of leasing …. Contd…

• C. ballooned
– Denote Y as the ballooned payment to be made in year 5.
– Therefore 4 x PVIFA(20%,4)+Y*PVIF(20%,5)= 40
– Y= Rs.73.76 lakhs

• D. Deferred ( Assume a deferment period of 2 years)

• Denote Y as the equated rentals to be charged between
years 3 and 5 .
• Therefore ,
YxPVIF(20%,3)+YxPVIF(20%,4)+YxPVIF(20%,5)=40
• Y=Rs.27.34 lakhs.

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Advantages of leasing …. Contd…

• This flexibility associated with leasing is not
typically found in debt servicing pattern
associated with a conventional loan.

– Typically a conventional loan requires the loan

amount to be repaid over a specified number of
installments.

– This may be inconvenient for projects which expect to

generate substantial cash flows in the later years.

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Advantages of leasing …. Contd…

• 2)Saving of capital :
– Enables the lessee to have finance for the huge
investments in land, building, plant and machinery, heavy
equipments and so on, up to 100% without requiring any
immediate down payments.

• 3) freed from restrictive covenants

– Lease finance is free from restrictive covenants and
conditionality, such as representation on board, conversion
of debt into equity etc. which may accompany
institutional finance and term loan from banks.
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Advantages of leasing …. Contd…

• 4) Leasing provides great operating flexibility. Leasing may
not be necessarily less expensive than buying, but the
operating flexibility is quite valuable.
– Airlines constantly drop and add routes in response to the
changing competitive conditions. And because different
types of aircrafts are better suited to serve some routes
than others, airlines are required to restructure their fleets
for optimal operations.
– If an airlines had purchased all its aircraft, it could not
possibly have responded so quickly to changing conditions.
Availability of leasing institutions provides that added
flexibility to airlines.

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Advantages of leasing …. Contd…

• 5) Lease finance usually involves much less documentation and
formalities than institutional finance and term loans.

• 6) Tax Benefits :Lease rentals are treated as normal expenses for

tax considerations. The lessee can derive a lot of tax advantage by
suitably structuring the lease rentals.
– If he is expecting high earnings and therefore high taxes, in some
years, the rental may be increased to lower his taxable income in
those years. Similarly in relatively lean years, the rentals may be
lowered.

• 7) Risk of obsolescence avoided.

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Advantages of Leasing …… contd….

• To The Lessor:
• Tax benefits: The lessor gets the depreciation
advantage of the asset for tax considerations( for
operating leases).
– If the lessor is in high tax bracket he can lease out assets(
not currently in use) with high depreciation rate.

• Lease rentals can be structured suitably to obtain

maximum tax advantage
– during high expected earnings years , the lease rentals
may be made less etc.

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The Cash Flows of Leasing.. Example

• Consider a firm, ClumZee Movers, that wishes to acquire a
delivery truck. The truck is expected to reduce costs by
$4,500 per year. The truck costs $25,000 and has a useful life
of 5 years. If the firm buys the truck, they will depreciate it
straight-line to zero. They can lease it for 5 years from Tiger
Leasing with an annual lease payment of $6,250. The tax rate
for both firms is 34%. The pre tax cost of debt for both firms
is 7.58% ( i.e post tax rate =5%). For simplicity let us assume
the lease rentals are paid at the end of years 1 to 5. (
typically in real life they are paid at the beginning ). We
ignore maintenance and insurance costs and residual value .
What are the relevant cash flows for the lessee ( Clum zee )
and lessor ( Tiger leasing) ?
• Session 17_18-problems and examples.xlsx

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The Cash Flows of Leasing for Lessee

• Cash Flows: Buy
Year 0 Years 1-5
Cost of truck –$25,000
After-tax savings 4,500×(1-.34) = $2,970
Depreciation Tax Shield _ 5,000×(.34) = $1,700
–$25,000 $4,670

• Cash Flows: Lease

Year 0 Years 1-5

Lease Payments –6,250×(1-.34) = –$4,125

After-tax savings 4,500×(1-.34) = $2,970

–$1,155

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The Cash Flows of Leasing for Lessee

Cash Flows: Leasing Instead of Buying ( =
leasing minus buying )
Year 0 Years 1-5
$25,000 –$1,155 – $4,670 = –$5,825
We could also view the cash flows as buying
minus leasing, which would simply change the
signs on the cash flows.
The discount rate is the aftertax rate on the firm’s
secured debt= 5%
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NPV Analysis of the Lease-vs.-Buy Decision

• A lease payment is like the debt service on a secured bond
issued by the lessee. Hence the discount rate typically used
for the cash flows of leasing is the after tax cost of debt of
the lessee.

• Therefore by discounting all cash flows of leasing as derived

in the previous slide at the after-tax interest rate on secured
debt issued by the lessee i.e 5%, we get ,

• NPV Leasing Instead of Buying=

• +25000 + PVIFA(5%, 5)*(-5825) = -$219.23

• If we had calculated NPV of buying instead of leasing ( i.e

NPV of buying minus leasing ) it would be + $219.23 as the
cash flow signs would be just reverse.
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Does Leasing Ever Pay: The Base Case

• In the above example, ClumZee Movers should choose to
buy, because the NPV of leasing was - $219.20
• Note that this is the opposite of the NPV that Tiger Leasing
would have:
• Cash Flows: Tiger Leasing
Year 0 Years 1–5
Cost of truck –$25,000
Depreciation Tax Shield 5,000×(.34) = $1,700
Lease Payments 6,250×(1-.34) = $4,125
–$25,000 $5,825

Therefore , the NPV of tiger leasing = -25000 + PVIFA( 5%, 5)*5825 = + $219.23.

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Real Life .. Why should the lease

happen at all ?
• If the NPV of a lease contract is same with opposite
signs as in the case discussed, the lease contract might
not happen at all… because the party with a negative
NPV will not agree to get into the contract. This will
typically be the case if
– both the parties are in the same tax bracket ( having the
same rate ) and
– the same pre tax or post tax debt rate.

• However in real life due to the differences in tax rate

and debt rate the lease contract can be beneficial for
both parties.

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Tiger Leasing’s Breakeven Lease rental

(Reservation Price)
• What is the smallest lease payment that Tiger
Leasing will accept? Set their NPV to zero and solve
for $Lmin:
Year 0 Years 1-5
Cost of truck -$25,000
Depreciation Tax Shield 5,000×(.34) = $1,700
Lease Payments $Lmin × (1 –.34) = $Lmin × (1 –.34)
-$25,000 $1,700 + $Lmin × (1 –.34)

5
$1,700
.66 ´ Lmin + $1,700 $25,000 - å
5
NPV = 0 = -$25,000 + å (1.05) t
t =1 (1.05) t Lmin = t =1
5
$1
.66 ´ å
5 5
$1 $1,700
$25,000 = .66 ´ Lmin å +å t
t t t =1 (1.05)
t =1 (1.05) t =1 (1.05)
Lmin = $6,173.29
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ClumZee Mover’s Breakeven Payment( reservation price)

• Suppose Clumzee is in the 25% tax bracket. And

its debt rate is 6.6667% such that after tax rate is
( 6.6667% X ( 1-0.25) = 5%. What is the highest
lease payment that ClumZee Movers can pay?

• Set their NPV to zero and solve for $Lmax

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ClumZee Mover’s Breakeven Payment

Cash Flows of Clusmy movers
Lease -
Leasing payments 0 4524.37 -4524.37 -4524.37 -4524.37 -4524.37 tax rate 25%
after tax Lease
savings 3375 3375 3375 3375 3375 payment 6032.49
-
Total 0 1149.37 -1149.37 -1149.37 -1149.37 -1149.37 Discounts rate 6.6667%

Discount rate
Buying cost of truck -25000 post tax 5.0000%
after tax
savings 3375 3375 3375 3375 3375 Pre tax savings 4500
depreciation
tax shield 1250 1250 1250 1250 1250
Total -25000 4625 4625 4625 4625 4625 Hence no lease
will happen in this
Leasing case as maximum
minus -
buying 25000 5774.37 -5774.37 -5774.37 -5774.37 -5774.37 payment for
NPV ( Clumzee is less
leasing than minimum
minus
buying ) or
rental for Tiger
NAL 0.00 leasing.
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A Possible Tax Arbitrage

• Suppose ClumZee movers is actually in the 15% tax
bracket and Tiger Leasing is in the 34% tax bracket.
• And suppose Clum Zee has a debt rate = 8% pre tax .
Everything else remains same .
• Let us repeat the analysis .
• Can both firms have a positive NPV?

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Analysis from Tiger leasing’s perspective

tax rate 0.34

Lease payment /year 6250

Discount rate 7.58%

Discount rate post tax 5.00%

Cash flow of Tiger leasing

year
0 1 2 3 4 5
Initial
Investment -25000
Depreciation
tax shield 1700 1700 1700 1700 1700
Lease
payments 4125 4125 4125 4125 4125

Total CF -25000 5825 5825 5825 5825 5825

219.23 ( same
NPV @ 5% as before)
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Analysis from Clum Zee’s perspective

tax rate 15%

Lease payment 6250
Discounts rate 8.00%
Discount rate post tax 6.80%
Pre tax savings 4500

Cash Flows of Clusmzee movers

Lease payments(
Leasing after tax) 0 -5312.5 -5312.5 -5312.5 -5312.5 -5312.5
after tax savings 3825 3825 3825 3825 3825
Total 0 -1487.5 -1487.5 -1487.5 -1487.5 -1487.5

buying cost of truck -25000

after tax savings 3825 3825 3825 3825 3825
depreciation tax
shield 750 750 750 750 750
Total -25000 4575 4575 4575 4575 4575

Leasing minus
buying 25000 -6062.5 -6062.5 -6062.5 -6062.5 -6062.5
NPV ( leasing
minus buying ) or
NAL 8.87
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Practice problem 1
Use the following information to work the problems i-v. A nuclear research
laboratory is contemplating leasing a diagnostic scanner . The scanner costs
$3,000,000 and it would be depreciated on a straight line basis to zero over four
years. The lab can lease it for $895,000 per year for four years.
i) Lease or buy ( from lessee’s perspective) : Assume that the tax rate is 35%. You can
borrow at 8% before taxes. Should you lease or buy?
ii) Leasing cash flows( from lessor’s perspective) : What are the cash flows/NPV from
the lease from the lessor’s view point? Assume a 35% tax bracket .
iii) Finding the break even payment : What would the lease payment have to be for
both lessor and lessee to be indifferent about the leasing ?
iv) Taxes and leasing cash flows : Assume that the lab does not contemplate paying
taxes for the next several years . What are the cash flows from leasing in this case ?
NAL ?
v) Setting the lease payment : In the previous problem( no iv) over what range of
lease payments will the lease be profitable for both parties ?
• Leasing : NAL =20187, -20187, 903799, 35646, 903799 to 905762.

Session 17_18-problems and examples.xlsx

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Practice Problem 2
• Quartz corporation is a relatively new firm. Quartz has
experienced enough losses during its early years to provide it
with at least 8 years of tax loss carry forward option. Thus
Quartz’s effective tax rate is 0. Quartz plans to lease an equipment
from New leasing company . The term of the lease is 5 years . The
purchase cost of the equipment is $650,000. New leasing
company is in the 35% tax bracket. There are no transaction costs
to the lease. Each firm can borrow at 7%.
• 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 ?
• 158,529,
• 158,109

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Practice Problem 3
Use the following information to work problems i) to iii). The WildCat Oil Co.
is trying to decide whether to lease or buy a new computer assisted drilling
system for its oil exploration business. Management has decided that it must
use the system to stay competitive, it will provide $700,000 in annual pre tax
cost savings . The system costs $6 million and will be depreciated straight line
to zero over 5 years. Wildcat’s tax rate is 34%, and the firm can borrow at 9%.
Lambert leasing company has offered to lease the drilling equipment to
Wildcat for payments of $1400,000 per year. Lambert’s policy is to require it’s
lessee’s to make payments at the start of the year.
i) Lease or buy What is the NAL for Wildcat? What is the maximum lease
payment that would be acceptable to the company ?
ii) Leasing and salvage Value Suppose it is estimated that the equipment will
have an after-tax residual value of $500,000 at the end of the lease . What is
the maximum lease payment acceptable to Wildcat now ?
iii) Deposits in leasing Many lessor’s require a security deposit in the form of
a cash payment or other pledged collateral. Suppose Lambert requires Wildcat
to pay a $200,000 security deposit at the inception of the lease. If the lease
payment is still $1400,000 is it advantageous for Wildcat to lease the
equipment now ?
148385, 1450298, 1323290,98260

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