Finance

Question 1

Lease Benefits

Answer 1

• There are higher tax benefits for the lessor, lowering the lease costs for the lessee.
• It’s a good alternative when the lessee does not qualify for debt financing.
• The implicit lease interest rate is less than the lessee’s incremental borrowing rate.
• No restrictive covenants are required.
• The lessor, being a specialist, may be able to sell the asset more readily in the secondary market, lowering default risk and lease payments.
• Lease terms may be longer than bank loans, resulting in lower annual payments and preserving operating cash flow for other uses.
• The lessor may have specialized knowledge about the type of asset that the lessee requires, saving the lessee time and costs to research it.
• The lessor may cover annual operating costs.
• It allows the lessee to temporarily use the asset for as long as required and then return it.
• The lessee avoids obsolescence risk with a short-term lease.

Question 2

Lease Disadvantages

Answer 2

• If the lessee has a good credit rating, the implicit lease interest rate may be higher than the lessee’s incremental borrowing costs.
• The lessee will lose any tax benefits arising from ownership of the asset, such as CCA deductions and interest expenses.
• Leases are not available on all assets.
• The lessor may restrict the use of the leased asset.
• If the residual value is guaranteed, the lessee may need to raise additional funds if the asset is not worth the guaranteed amount.

Question 3

Valuation Methods

Answer 3

Asset-based approaches:
o liquidation
-Used when a company is not a going concern
o adjusted net asset
-Used when the company does not have active operations or if an entity has active operations but does not have excess earnings
o replacement cost

Income-based approaches:
o capitalized cash flow
If an entity has consistent cash flows that are reflective of the future operations, value based on historical cash flow
o discounted cash flow
-If the entity is in the startup stage, the historical cash flow may be negative
-Also appropriate if past cash flows not representative of future cash flows and management is able to prepare reliable projections of future cash flow
o capitalized earnings
-Based on historical earnings of the company.
-Earnings are multiplied by a multiplier or divided by a capitalization rate to determine the value
o discounted earnings
-Used in merger and acquisition valuations
-Future earnings are expected to be volatile
-Earnings during the volatile years are valued separately
-Estimates of future earnings for each forecasted period are determined.
-The estimated earnings for each year are discounted at the appropriate discount rate to determine present value.

Market-based approaches

• Used when the company is a going concern and information required to determine a valuation multiple is publicly available and reasonably comparable.
• Used as a corroborative approach to other income-based approaches.
• Market data is used to determine a valuation multiple based on valuation multiples
• The valuation multiple is then applied to the entity’s EBITDA to obtain a market-based value
• To obtain a market-based value, a valuation multiple is applied to net earnings.