# Ch021 - Chapter 21 Leasing 21.1 a b Leasing can reduce...

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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 debt-to-equity ratios. d. 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. 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 After-tax 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. B-106

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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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