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.