Leasing can reduce uncertainty regarding the resale value of the asset that is leased.
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
Thus, leasing does not provide 100% financing.
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 debt-to-equity ratios.
If the tax advantages of leasing were eliminated, leasing would probably disappear.
The main reason for the existence of long-term leasing is the differential in the tax
rates paid by the lessee and the lessor.
The reservation payment is found by setting the NPV of the lease to $0, and then
solving for the lease payment.
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:
after tax PV(lease payments)
= $250,000 - L (
= $250,000 - L (3.9927)
The lease payment is Quartz’s reservation price.
i.e. for L > 62,614.11, Quartz will have NPV<0.
For New Leasing, the lessor:
after tax PV(Lease payments)
PV(Depr tax shield)
= $250,000 / 5
= $50,000 per annum
Depreciation tax shield = $50,000
After-tax discount rate = 0.08 (1 - 0.35)
As in part a., set NPV = 0, and solve for L:
= -$250,000 + L (1 - 0.35)
This lease payment is New Leasing Co’s reservation price.
i.e. for L < 62,405.09, New Leasing will have NPV<0.