B362
Chapter 21:
Leasing
21.1
a.
Leasing can reduce uncertainty regarding the resale value of the asset that is leased.
b.
Leasing does not provide 100% financing although it may look as though it does.
Since firms must try to maintain their optimal debt ratio, the use of lease simply
displaces debt.
Thus, leasing does not provide 100% financing.
c.
Although it is true that leasing displaces debt, empirical studies show that the
companies that do a large amount of leasing also have a high debttoequity ratios.
d.
If the tax advantages of leasing were eliminated, leasing would probably disappear.
The main reason for the existence of longterm leasing is the differential in the tax
rates paid by the lessee and the lessor.
21.2
The reservation payment is found by setting the NPV of the lease to $0, and then
solving for the lease payment.
a.
For Quartz Corp, the lessee:
Since Quartz's effective tax rate is 0, the after tax discount rate is 8%.
Set the NPV = 0, and solve for L:
NPV (lease)
= Cost

after tax PV(lease payments)
0
= $250,000  L (
5
08
.
0
Α
)
= $250,000  L (3.9927)
L
= $62,614.11
The lease payment is Quartz’s reservation price.
i.e. for L > 62,614.11, Quartz will have NPV<0.
b.
For New Leasing, the lessor:
NPV
= Cost
+
after tax PV(Lease payments)
+
PV(Depr tax shield)
Depreciation
= $250,000 / 5
= $50,000 per annum
Depreciation tax shield
= $50,000
×
0.35
= $17,500
Aftertax discount rate
= 0.08 (1  0.35)
= 0.052
As in part a., set NPV = 0, and solve for L:
NPV (lease)
=
0
= $250,000 + L (1  0.35)
5
052
.
0
Α
+ $17,500
5
052
.
0
Α
L
= $62,405.09
This lease payment is New Leasing Co’s reservation price.
i.e. for L < 62,405.09, New Leasing will have NPV<0.
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B363
c.
A lease payment less than $62,405.09 will give New Leasing a negative NPV.
A
payment higher than $62,614.11 will give Quartz a negative NPV.
In either case, no
deal will be struck.
Therefore, these represent the lower and upper bounds of
possible lease prices during negotiations.
21.3
Use the method of Incremental NPV as demonstrated in Table 21.3 in text.
First, find the deprecation benefit (which will be lost if lease rather than purchase)
= 350,000 / 5 ( .35)
= $24,500
Second, find after tax discount rate
=
.11 ( 1.35)
=
.0715
Now, put it together for the incremental cash flows from leasing instead of
purchasing:
Lease minus Buy
Year 0
Year 1  5
Lease
Lease payment
$94,200
Tax benefit of lease payment
$32,970
Buy
Cost of machine
$350,000
Lost depreciation tax benefit
$24,500
Lease – Buy
$350,000
$85,730
Now find the NPV to make the lease/buy decision.
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 Summer '06
 TimothyDreyer
 Finance, Depreciation, Leasing, Debt, Net Present Value, Operating cash flow

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