LO1 The basics of a lease and the different types of leases.
LO2 How accounting rules and tax laws define financial leases.
LO3 The cash flows from leasing.
LO4 How to conduct a lease versus buy analysis.
LO5 How lessee and lessor can both benefit from leasing.
LO6 The difference between good and bad reasons for leasing.
Answers to Concepts Review and Critical Thinking Questions
1. (LO1) Some key differences are: (1) Lease payments are fully tax-deductible, but only the interest
portion of the loan is; (2) Lessee does not own the asset and cannot depreciate it for tax purposes; (3) In
the event of a default, lessor cannot force bankruptcy; and (4) Lessee does not obtain title to the asset at
the end of the lease (absent some additional arrangement).
2. (LO2) The less profitable one because leasing provides, among other things, a mechanism for
transferring tax benefits from entities that value them less to entities that value them more.
3. (LO4) Potential problems include: (1) Care must taken in interpreting the IRR (a high or low IRR is
preferred depending on the setup of the analysis); and (2) Care must be taken to ensure the IRR under
examination is not the implicit interest rate just based on the lease payments.
a. Leasing is a form of secured borrowing. It reduces a firm’s cost of capital only if it is cheaper than
other forms of secured borrowing. The reduction of uncertainty is not particularly relevant; what
matters is the NAL.
b. The statement is not always true. For example, a lease often requires an advance lease payment or
security deposit and may be implicitly secured by other assets of the firm.
c. Leasing would probably not disappear, since it does reduce the uncertainty about salvage value
and the transactions costs of transferring ownership. However, the use of leasing would be greatly
5. (LO2) A lease must be disclosed on the balance sheet if one of the following criteria is met:
1. The lease transfers ownership of the asset by the end of the lease. In this case, the firm essentially
owns the asset and will have access to its residual value.
2. The lessee can purchase the asset at a price below its fair market value (bargain purchase option)
when the lease ends. The firm essentially owns the asset, and will have access to most of its
3. The lease term is for 75% or more of the estimated economic life of the asset. The firm basically
has access to the majority of the benefits of the asset, without any responsibility for the
consequences of its disposal.
4. The present value of the lease payments is 90% or more of the fair market value of the asset at the
start of the lease. The firm is essentially purchasing the asset on an installment basis.
6. (LO2) In order for the CRA to count a lease as valid, it must be for business purposes, not for tax
avoidance. If there is any clause which involves the lessee acquiring title to the property, then the CRA
does not consider it a lease and no tax advantages are given. Specifically, a lease will be disallowed if:
22-1 1. The lessee automatically acquires title to the property after payment of a specified amount in the
form of rentals.
2. The lessee is required to buy the property from the lessor during or at the termination of the lease.
3. The lease should not contain a bargain purchase option, which the CRA interprets as an equity
interest in the asset.
7. (LO2) As the term implies, off-balance sheet financing involves financing arrangements that are not
required to be reported on the firm’s balance sheet. Such activities, if reported at all, appear only in the
footnotes to the statements. Operating leases provide off-balance sheet financing. For accounting
purposes, total assets will be lower and some financial ratios may be artificially high. Financial analysts
are generally not fooled by such practices. There are no economic consequences, since the cash flows of
the firm are not affected by how the lease is treated for accounting purposes.
8. (LO1, 6) The lessee may not be able to take advantage of the depreciation tax shield and may not be
able to obtain favorable lease arrangements for “passing on” the tax shield benefits. The lessee might
also need the cash flow from the sale to meet immediate needs, but will be able to meet the lease
obligation from cash flows in the future.
9. (LO4) Since the relevant cash flows are all after-tax, the after-tax discount rate is appropriate.
10. (LO4) There is the tax motive, but, beyond this, the leasing company knows that, in the event of a
default, Air Canada would relinquish the planes which would then be re-leased. Tangible assets, such as
planes, which can be readily reclaimed and redeployed are good candidates for leasing.
11. (LO4) They will be re-leased to Air Canada or another air transportation firm, or they will simply be
sold. There is an active market for used aircraft.
Solutions to Questions and Problems
1. (LO4) Tax shields are assumed to be claimed at the beginning of the year.
0 1 2 3
Lease payment -9,000 -9,000 -9,000
Payment shield 3,600 3,600 3,600
Forgone tax shield -1,440 -2,448 -1,714 -3,998
Total cash flow $17,160 -$7,848 -$7,114 -$3,998
NAL 6% = $67.99
2. (LO4) Assuming end of year lease payments:
I=$4,500,000, SV 40, L=$1,340,000/yr., d = 30%, T = 37%, and r = 7.5%
The after-tax cost of debt is 7.5(1–.37) = 4.725%
PV of CCATS = 4,500,000(.3)(.37) x (1 + .5(.04725)) = $1,405,994.93
.04725 + .30 1 + .04725
NAL = 4,500,000 – 1,340,000(1–.37) x PVIFA (4.725%, 4) – 1,405,994.93 = $81,291.87
22-2 Therefore, the firm should lease the equipment.
3. (LO4) A gain for the lessee means a loss for the lessor = –$81,291.87
4. (LO4) NAL = 0 = $4,500,000 – X(PVIFA 4.725%,4– 1,405,994.93
X = $866,979.00 is the break-even after-tax lease payment.
Before tax lease payment = $866,979.00/0.63 = $1,376,157.14
5. (LO3) If the tax rate is zero, there is no depreciation tax shield foregone, the