Ch. 25: Leasing

Question 1

Which of the following statements hold true for a lease?
A) a rental agreement where lessor gives lessee the right to use an asset for a given period in exchange for periodic payments
B) an alternative to buying capital equipment
C) involves a lessee and lessor of the asset
D) the time pattern on lease agreements may be tailored to the user’s needs
E) when the lease is terminated, the leased equipment reverts to the lessor but often, the agreement gives the lessee the option to buy the equipment or take a new lease

Answer 1

All options are correct

Question 2

What is an operating lease?

Answer 2

Short-term lease that can be canceled by the lessee before the end of the contract period

Question 3

Who bears the business risk in a short-term operating lease?

Answer 3

The lessor bears the risk of ownership (business risk), since lessee can terminate contract before expiration of the agreement

Question 4

Which of the following is true for a financial/capital/full-payout lease? (Select all correct)
A) extends over most of the estimated economic life of the asset
B) cannot be cancelled or only cancelled if the lessor is reimbursed for any losses
C) lessee bears the risk of ownership (business risk)
D) such lease payments are fixed obligations equivalent to debt service

Answer 4

All options are correct

Question 5

When the lessor is responsible for maintaining and insuring the leased equipment and to pay any property taxes due on it, this is a:
A) full-service/ rental lease
B) net lease

Answer 5

A) full-service/ rental lease

Question 6

When the lessee is responsible for maintaining and insuring the leased equipment and to pay any property taxes due on it, this is a:
A) full-service/ rental lease
B) net lease

Answer 6

B) net lease

Question 7

operating leases often work as:
A) net lease
B) full service, rental lease

Answer 7

B) full service, rental lease

Question 8

financial leases often work as:
A) net lease
B) full service, rental lease

Answer 8

A) net lease

Question 9

A lease where the asset is brand new, and the lessee identifies what he needs and arranges for the leasing company to buy it in order to lease it to the lessor. This is a case of:
A) leveraged leases
B) sale and lease-back arrangement
C) direct lease

Answer 9

C) direct lease

Question 10

The firm sells an asset it already owns and leases it back from the buyer. This is a:
A) leveraged leases
B) sale and lease-back arrangement
C) direct lease

Answer 10

B) sale and lease-back arrangement

Question 11

What is a leveraged lease?

Answer 11

The lessor borrows part of the purchase price of the leased asset, using the lease contract as security for the loan

Question 12

Which of the following is NOT a sensible reason for leasing?
A) convenience
B) cancellation option being valuable
C) avoidance of asset maintenance hurdles
D) standardization leading to low administrative and transaction costs for lessor than if lessee where to buy
E) tax shield benefits
F) lessors may fare better than lenders in bankruptcy
G) avoiding CAPEX controls
H) lessees may sidestep the limitation on debt interests

Answer 12

G) avoiding CAPEX controls
This is a dubious reason for leasing

Question 13

Short-term leases can be convenient when the equipment is only needed for a short period of time (this will always be an operating lease)
True/ False

Answer 13

True

Question 14

The cost of short-term rentals can be prohibitively high if the equipment is easily damaged by careless use, in which case the short-term agreement will not work

True/ False

Answer 14

True

Question 15

One of the sensible reasons for leasing is the larger operational ease of the asset when maintenance is provided by lessor
True/ False

Answer 15

True

Question 16

Leasing is a sensible alternative to buying for smaller firms with few assets to support a debt issue. Meanwhile, leasing entails lower transaction costs than e.g., a bond or stock issue

True/ False

Answer 16

True

Question 17

A sensible reason for leasing is that tax shield benefits may be exploitable - how?
Hint: from the lessor’s POV

Answer 17

The lessor owns the leased asset and can deduct its depreciation from taxable income.

Question 18

If the lessee goes bankrupt, the lessor may be in a better position than the lessee’s other creditors. Why?

Answer 18

If the bankruptcy court decides that the leased asset is essential to the lessee’s business, the bankrupt firm can continue to use the asset if it still makes the lease payments. This is good news for the lessor, who is paid while other creditors cool their heels

Question 19

The lessor can recover the leased asset, and if it is worth less than the PV of the remaining lease payments, the lessor can try to recoup this loss.
In this case, the lessor is in the front of the line relative to unsecured creditors

True/ False

Answer 19

False:
In this case, the lessor must get in line with unsecured creditors

Question 20

If the lessee goes bankrupt, the court may grant them the ability to renegotiate with lessor. What does this mean?
Hint: this is bad news for the lessor

Answer 20

In this case, the lessee in financial distress may be able to renegotiate the lease, forcing the lessor to accept lower lease payments

Question 21

Companies in some jurisdictions are subject to interest-deductibility limits (limits on how much interest expenses can be tax deductible), in which case leasing is a sound options to sidestep the limitation.

This is a sensible reason for leasing

True/ False

Answer 21

True

Leases have rental payments that are fixed obligations like debt interest, but face no restriction on the tax deductibility. This is classified as a sensible reason for leasing

Question 22

Leasing in order to avoid internal CAPEX controls is a sensible/ dubious reason for lease

Sensible or dubious?

Answer 22

Dubious

In some firms, lease proposals are not scrutinized as carefully as CAPEX proposals, wherefore leasing may enable an operating manager to avoid the approval procedures needed to buy an asset. This is a dubious reason for leasing

Question 23

Leasing as a means to preserve capital for other investments is a sensible/ dubious reason for lease

Sensible or dubious?

Answer 23

Dubious

Question 24

What is the decision rule for operating lease?

Answer 24

Lease versus buy

A firm should buy the asset if the equivalent annual cost of ownership and operation is less than the best lease rate the firm can get from an outsider lessor

Question 25

In an operating lease, where the lessor bears the risk of ownership, the discount rate used by the lessor to compute the right leasing payment to be charged should include a premium sufficient to compensate for the risk of buying and holding the leased asset. Which of the following costs should be covered in this discount rate assuming a competitive leasing industry? (Multiple may be correct)

A) cost of negotiation and administering the lease
B) compensation for the foregone revenues when asset is off-lease and idle
C) a profit markup corresponding to the market power of the lessor

Answer 25

A) cost of negotiation and administering the lease
B) compensation for the foregone revenues when asset is off-lease and idle

Note: C is wrong: in a competitive leasing industry, the rental payment should only be sufficient to cover the PV of all the costs of owning and operating the asset

Question 26

Why may an operating lease be less costly than buying from an efficiency POV?

Answer 26

Leasing companies may have higher bargaining power towards suppliers, and more efficient service operations allowing for the ability to offer the asset at lower total cost than if the lessee was to buy it

Question 27

In a financial (net), capital, full-payout lease, the lease payments are fixed obligations equivalent to debt service
True/ False

Answer 27

True

Question 28

Th decision rule for a financial (net), capital, full payout lease is _____

Answer 28

Lease versus borrow

Question 29

In principle: financial leases are just another way of borrowing money to pay for an asset.

True/ False

Answer 29

True

The user could have borrowed the full purchase price of the asset by accepting a binding obligation to make interest and principal payments to the lender. Thus the cash-flow consequences of leasing and borrowing are similar.

Question 30

From a legal/ accounting point of view, who is the owner of the leased asset in a financial lease?
A) Lessee
B) Lessor

Answer 30

B) Lessor

The lessor is the legal owner of the leased asset, which is why the lessor is allowed to deduct depreciation from taxable income

Question 31

From an economic point of view, who is the owner of the leased asset in a financial lease?
A) Lessee
B) Lessor

Answer 31

A) Lessee

The user is the real owner because, in a financial lease, the user faces the risks and receives the rewards of ownership

Question 32

Which discount rate should be used to discount incremental cash flows from a financial lease?

A) cost of equity
B) pre-tax cost of debt
C) WACC
D) after-tax cost of debt

Answer 32

D) after-tax cost of debt

To value the incremental cash flow from a lease, the discount rate used is the after-tax interest rate that the firm would pay on an equivalent loan

Question 33

If the NPV of a lease is negative, it means that the lessee should not undertake the project

True/ False

Answer 33

False:
If the lease has a negative NPV, the firm is better off borrowing and buying the asset rather than leasing - if you decide the acquire the asset - i.e., the NPV does not tell you whether to undertake the project - only if you should lease versus borrow/buy

Question 34

If the firm leases the asset instead of raising an equivalent loan, there will be $NPV less/more in the firm’s bank account

True/ False

Answer 34

True

Question 35

One shall view financial leases as a three-person zero-sum game - i.e., the three parties can only win/gain on the other parties’ expense. Who are the three parties?

Answer 35

Lessor, lessee, government

Question 36

The debt in a leveraged lease is nonrecourse - what does this mean?

A) lenders have first claim on the lease payments and the asset if the lessee fails to make the scheduled payments, and has a claim on the lessor (borrower) if the loaned amount exceeds the value of the collateral (asset)

B) lenders have first claim on the lease payments and the asset if the lessee fails to make the scheduled payments, but has no claim on the lessor company - lenders must depend solely on the lessee’s credit and the asset as collateral

Answer 36

B) lenders have first claim on the lease payments and the asset if the lessee fails to make the scheduled payments, but has no claim on the lessor company - lenders must depend solely on the lessee’s credit and the asset as collateral

Question 37

In a leveraged leased, lenders will demand a higher interest rate in exchange for giving up recourse

True/ False

Answer 37

True

Question 38

In a leveraged lease, the leasing company puts up only a small % of the money from own pockets, gets 100% of the tax shields, but is not on the hook if the lease transaction falls apart

True/ False

Answer 38

True