Ch. 25: Leasing Flashcards
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
All options are correct
What is an operating lease?
Short-term lease that can be canceled by the lessee before the end of the contract period
Who bears the business risk in a short-term operating lease?
The lessor bears the risk of ownership (business risk), since lessee can terminate contract before expiration of the agreement
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
All options are correct
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
A) full-service/ rental lease
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
B) net lease
operating leases often work as:
A) net lease
B) full service, rental lease
B) full service, rental lease
financial leases often work as:
A) net lease
B) full service, rental lease
A) net lease
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
C) direct lease
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
B) sale and lease-back arrangement
What is a leveraged lease?
The lessor borrows part of the purchase price of the leased asset, using the lease contract as security for the loan
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
G) avoiding CAPEX controls
This is a dubious reason for leasing
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
True
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
True
One of the sensible reasons for leasing is the larger operational ease of the asset when maintenance is provided by lessor
True/ False
True
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
True
A sensible reason for leasing is that tax shield benefits may be exploitable - how?
Hint: from the lessor’s POV
The lessor owns the leased asset and can deduct its depreciation from taxable income.
If the lessee goes bankrupt, the lessor may be in a better position than the lessee’s other creditors. Why?
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
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
False:
In this case, the lessor must get in line with unsecured creditors
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
In this case, the lessee in financial distress may be able to renegotiate the lease, forcing the lessor to accept lower lease payments
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
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
Leasing in order to avoid internal CAPEX controls is a sensible/ dubious reason for lease
Sensible or dubious?
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
Leasing as a means to preserve capital for other investments is a sensible/ dubious reason for lease
Sensible or dubious?
Dubious
What is the decision rule for operating lease?
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
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
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
Why may an operating lease be less costly than buying from an efficiency POV?
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
In a financial (net), capital, full-payout lease, the lease payments are fixed obligations equivalent to debt service
True/ False
True
Th decision rule for a financial (net), capital, full payout lease is _____
Lease versus borrow
In principle: financial leases are just another way of borrowing money to pay for an asset.
True/ False
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.
From a legal/ accounting point of view, who is the owner of the leased asset in a financial lease?
A) Lessee
B) Lessor
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
From an economic point of view, who is the owner of the leased asset in a financial lease?
A) Lessee
B) Lessor
A) Lessee
The user is the real owner because, in a financial lease, the user faces the risks and receives the rewards of ownership
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
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
If the NPV of a lease is negative, it means that the lessee should not undertake the project
True/ False
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
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
True
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?
Lessor, lessee, government
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
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
In a leveraged leased, lenders will demand a higher interest rate in exchange for giving up recourse
True/ False
True
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
True
