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# CH26 - CHAPTER 26 Leasing Answers to Practice Questions 1...

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CHAPTER 26 Leasing Answers to Practice Questions 1. “100 percent financing” is not an advantage unique to the lessee because precisely the same cash flows can be arranged by borrowing as an alternate source of financing for the acquisition of an asset. 2. a. For comparison purposes, the solution to Quiz Question 5 is shown below: t = 0 t = 1 t = 2 t = 3 t = 4 t = 5 t = 6 Initial Cost -3000.00 Depreciation 600.00 960.00 576.00 345.60 345.60 172.80 Depreciation tax shield 210.00 336.00 201.60 120.96 120.96 60.48 After-tax admin. costs -260.00 -260.00 -260.00 -260.00 -260.00 -260.00 Total -3260.00 -50.00 76.00 -58.40 -139.40 -139.40 60.48 PV(at 9%) = -\$3,439.80 Break-even rent 1082.30 1082.30 1082.30 1082.30 1082.30 1082.30 Tax -378.81 -378.81 -378.81 -378.81 -378.81 -378.81 Break-even rent after tax 703.49 703.49 703.49 703.49 703.49 703.49 PV(at 9%) = -\$3,439.82 Cash Flow -2556.51 653.50 779.50 645.10 564.46 564.46 60.48 In the above table, we solve for the break-even lease payments by first solving for the after-tax payment that provides a present value, discounted at 9%, equal to the present value of the costs, keeping in mind that the annuity begins immediately. Then solve for the break-even rent as follows: Break-even rent = \$703.49/(1 – 0.35) = \$1,082.30 If the expected rate of inflation is 5 percent per year, then administrative costs increase by 5 percent per year. We further assume that the lease payments grow at the rate of inflation (i.e., the payments are indexed to inflation). However, the depreciation tax shield amounts do not change because depreciation is based on the initial cost of the desk. The appropriate nominal discount rate is now: (1.05 × 1.09) – 1 = 0.1445 = 14.45% These changes yield the following, indicating that the initial lease payment has increased from \$1,082 to about \$1,113: 240

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t = 0 t = 1 t = 2 t = 3 t = 4 t = 5 t = 6 Initial Cost -3000.00 Depreciation 600.00 960.00 576.00 345.60 345.60 172.80 Depreciation. tax shield 210.00 336.00 201.60 120.96 120.96 60.48 After-tax admin. costs -260.00 -273.00 -286.65 -300.98 -316.03 -331.83 Total -3260.00 -63.00 49.35 -99.38 -195.07 -210.87 60.48 PV(at 14.45%) = -\$3,537.83 Break-even rent 1113.13 1168.79 1227.23 1288.59 1353.02 1420.67 Tax -389.60 -409.08 -429.53 -451.01 -473.56 -497.23 Break-even rent after tax 723.53 759.71 797.70 837.58 879.46 923.43 PV(at 14.45%) = -\$3,537.83 Cash Flow -2536.47 696.71 847.05 738.20 684.39 712.56 60.48 Here, we solve for the break-even lease payments by first solving for the after-tax payment that provides a present value, discounted at 9%, equal to the present value of the costs, keeping in mind that the annuity begins immediately. We use the 9% discount rate in order to find the real value of the payments (i.e., \$723.53). Then each of the subsequent payments reflects the 5% inflation rate. Solve for the break-even rent as follows: Break-even rent = \$723.53/(1 – 0.35) = \$1,113.13 b. With a reduction in real lease rates of 10 percent each year, the nominal lease amount will decrease by 5.5 percent each year. That is, the nominal lease rate is multiplied by a factor of (1.05 × 0.9) = 0.945 each year. Thus, we have: t = 0 t = 1 t = 2 t = 3 t = 4 t = 5 t = 6 Initial Cost -3000.00 Depreciation 600.00 960.00 576.00 345.60 345.60 172.80 Depreciation. tax shield 210.00 336.00 201.60 120.96 120.96 60.48 After-tax admin. costs -260.00 -273.00 -286.65 -300.98 -316.03 -331.83 Total -3260.00 -63.00 49.35 -99.38 -195.07 -210.87 60.48 PV(at 14.45%) = -3537.83 Break-even rent 1388.85 1312.46 1240.28 1172.06 1107.60 1046.68 Tax -486.10 -459.36 -434.10 -410.22 -387.66 -366.34 Break-even rent after tax 902.75 853.10 806.18 761.84 719.94 680.34 PV(at 14.45%) = -3537.84 Cash Flow -2357.25 790.10 855.53 662.46 524.87 469.47 60.48 Here, when we solve for the first after-tax payment, use a discount rate of: [(0.9/1.09) – 1 = 0.2111 = 21.11% 241
3. If the cost of new limos decreases by 5 percent per year, then the lease payments also decrease by 5 percent per year. In terms of Table 26.1, the only change is in the break-even rent.

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