CF chapter 25

Question 1

Leasing contract

Answer 1

Contract allowing the firm to use specific assets for several years in exchange for periodic payments

Question 2

Lessee

Answer 2

the party in a lease using the asset and liable for the periodic payments

Question 3

Lessor

Answer 3

The party in a lease lending the asset and entitled to periodic payments

Question 4

Operational lease

Answer 4

Firm uses the asset during the contract term, after which it is returned to the lessor

Question 5

Financial lease

Answer 5

Firm has the obligation/right to buy the asset after the contract term

Question 6

Direct lease

Answer 6

The lessor is an independent company that specializes in purchasing assets and leasing them to customers

Very often subsidiaries of commercial banks

Question 7

Sales type lease

Answer 7

The lessor is the manufacturer of the asset, offering lease financing services

Usually through a financial services subsidiary

Question 8

Sale and lease-back

Answer 8

Firm already owns the asset, but would prefer to lease it
◦ Firm sells the asset to the lessor in return for cash
◦ Leases it back to continue using the asset

Question 9

Leveraged leases

Answer 9

The lessor borrows from a bank or other lender to obtain the initial capital to purchase the asset

The lessor uses the lease payments from the lessee to pay interest and principal on the loan

Question 10

Special purpose entity/vehicle

Answer 10

Separate business partnership created by the lessee for the sole purpose of obtaining a lease

Question 11

Synthetic lease

Answer 11

Lease that uses an SPE for lease constructions that are targeted to obtain specific favorableaccounting and/or tax treatments
6

Question 12

Primary determinants of lease payments

Answer 12

Residual value:
At the end of the leasing period, since (purchase price –residual value) will be
depreciated, and may differ for lessor or lessee

Other costs:
such as servicing and maintenance are (1) not that large, and (2) usually not very
different for lessor/lessee

Question 13

PV(lease payments) formula

Answer 13

PV(Lease payments) = Purchase price - PV(residual value)

Question 14

Fair market value leased (end of term options)

Answer 14

Lessee has the option to purchase the asset at its fair market value at the end of the lease term

◦ In perfect capital markets, there is no difference between an FMV lease and an operational lease

Question 15

Fixed price lease (end of term options)

Answer 15

Lessee has the option to purchase the asset at the end of the lease term for a fixed price that is set
upfront

Since the lessee has an option to purchase, he will buy the asset elsewhere if the fair market value is
lower than the fixed price

Question 16

Fair market value cap lease (end of lease options)

Answer 16

Lessee can purchase the asset at the minimum of its fair market value and a fixed price (or “cap”)

◦ Similar to the fixed price lease, but the lessee is not likely to go elsewhere to buy the asset at the end
of the lease term

Question 17

Lease provisions (examples)

Answer 17

Early cancellation option for the lessee (at a fee)

◦ Buyout option allowing the lessee to purchase the asset before the end of the lease term

◦ Trade-in clauses allowing the lessee to upgrade to a newer model at certain points in time during the
lease term

Question 18

Operating lease: accounting treatment

Answer 18

Viewed as rental of the asset

Question 19

Capital lease (accounting treatment)

Answer 19

viewed as acquisition with long-term financing

Question 20

Accounting treats any lease like a capital lease if:

Answer 20

Title to the property transfers to the lessee at the end of the lease term
◦ Lease contains an option to purchase the asset at a bargain price being substantially less than its fair
market value
◦ Lease term is 75% or more of the estimated life of the asset
◦ Present value of the minimum lease payments at the start of the lease is 90% or more of the asset’s
fair market value

Question 21

True tax lease

Answer 21

Lessor receives the depreciation deduction associated with the ownership of the asset

Lessee can deduct the full amount of the lease payments as an operating expense

Lease payments are treated as revenue for the lessor

Question 22

non-tax lease

Answer 22

Lessee receives the depreciation deduction for tax purposes

Lessee can also deduct the interest portion of the lease payments as an interest expense

The interest portion of the lease payment is interest income to the lessor

Question 23

Tax authorities will classify a lease as a non-tax lease if it satisfies any of

Answer 23

Lessee obtains equity in the leased asset
◦ Lessee receives ownership of the asset on completion of all lease payments
◦ Total amount that the lessee is required to pay for a relatively short period of use constitutes an
inordinately large portion of the value of the asset
◦ The lease payments greatly exceed the current fair rental value of the asset
◦ The property may be acquired at a bargain price in relation to the fair market value of the asset at
the time when the option may be exercised
◦ Some portion of the lease payments is specifically designated as interest or its equivalent

Question 24

The lease-equivalent loan is defined as

Answer 24

The loan that is required for the purchase of the asset that leaves the purchaser with the same net
future obligations as a lease would entail

Question 25

Suspect reasons for leasing

Answer 25

Avoid capital expenditure spending

*Preserve (working) capital

*Reduce leverage through off-balance sheet financing