chap021 - Chapter 21: Leasing 21.1 a. b. c. d. Leasing can...

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Unformatted text preview: Chapter 21: Leasing 21.1 a. b. c. d. 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 displaces debt. 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. NPV (lease) = $250,000 - L 0.08 = $250,000 - 3.9927 L = $0 L = $62,614.11 The lease payment is Quartz'a reservation price. 5 21.2 a. b. 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 5 5 NPV (lease) = -$250,000 + L (1 - 0.35) 0.052 + $17,500 0.052 = $0 L = $62,405.09 This lease payment is New Leasing Co's reservation price. If the lease price is greater than Quartz's reservation price, the lease is a negative NPV proposal for Quartz. Quartz would rather purchase the equipment than lease at a payment above its reservation price. Thus, the lessee's reservation price is the maximum of the negotiation range. c. Answers to End-of-Chapter Problems B-187 21.3 Incremental cash flows from leasing instead of purchasing: Lease minus Buy Lease Lease payment Tax benefit of lease payment Buy (minus) Cost of machine Lost depreciation tax benefit Total NPV = $350,000 - $85,730 0.11( 0.65 ) = -$102.66 < $0 The firm should buy the machine. 5 Year 0 Year 1 - 5 -$94,200 $32,970 -(-$350,000) $350,000 -$350,000/5 0.35 = -$24,500 -$85,730 24.4 Maxwell's reservation price: 5 NPV (lease) = $200,000 - L 0.10 = $200,000 - 3.7908 L = $0 L = $52,759.50 Mercer's reservation price: Depreciation= $200,000 / 5 = $40,000 per annum Depreciation tax shield = $40,000 0.35 = $14,000 After-tax discount rate = 0.10 (1 - 0.35) = 0.065 5 5 NPV (lease) = -$200,000 + L (1 - 0.35) 0.065 + $14,000 0.065 = $0 L = $52,502.94 Therefore, the negotiation range is from $52,502.94 to $52,759.50. 21.5 Reservation payment of Raymond: 5 Value of lease = $100,000 - 0.75 L 0.08( 0.75 ) = $0 L = $31,652.85 Reservation payment of Liberty: 100,000 5 Value of lease = -$100,000+ 0.35 0.08( 0.65 ) 5 L = $24,962.04 Therefore, the negotiation range is from $24,962.04 to $31,652.85. For lease payments higher than $31,652.85, Raymond will not enter into the arrangement. For lease payments lower than $24,962.04, Liberty will not enter into the arrangement. 21.6 a. The lease payment, which makes both parties equally well off, is the payment, which equates the NPVs for the firms. Since the tax rates of the two firms are Answers to End-of-Chapter B-188 Problems b. equal, the perspective of the lessor is the opposite of the perspective of the lessee. This condition ensures that the NPV is zero. After-tax cash flows to the lessor = L (1 - 0.34) + Depreciation (0.34) Depreciation = $86.87 / 2 = $43.435 The NPV is zero when the NPV of the lessor's after-tax cash flows equals the cost of the asset. The appropriate discount rate is the after-tax rate. That rate is 6.6% [= 10% 0.66]. 2 $86.87 = [0.66 L + $43.435 (0.34)] 0.066 $86.87 = [0.66 L + $43.435 (0.34)] (1.8181) L = $50.02 Generalize the result from part a. Let T1 denote the lessor's tax rate. Let T2 denote the lessee's tax rate. Let P denote the purchase price of the asset. Let Dep equal the annual depreciation expense. Let N denote the length of the lease in years. N L(1 - T ) + Dep(T ) 1 1 Value to the lessor = - P + t t =1 [1 + r (1 - T1 )] Value to the lessee = P - N L(1 - T2 ) + Dep(T2 ) [1 + r (1 - T2 )] t t =1 c. The values of the lease to its two parties will be opposite in sign only if T1 = T2. Since the lessor's tax bracket is unchanged, the lease has a zero NPV to the lessor when the lease payment is $50.02. If the lessee pays no taxes, the pre-tax and after-tax lease payment are the same. Also, one of the lessee's cash flows is the depreciation that is foregone when leasing is chosen over purchasing. If the lessee's tax rate is zero, it will not benefit from depreciation. Thus, if the lessee chooses leasing, the lost depreciation is no longer a cash flow. The lease has a zero NPV to the lessee when L = $50.05. 2 L 0.10 = $86.87 L = $86.87 / 1.7355 = $50.05 If L > $50.05 the NPV to the lessee is < $0. If L < $50.05 the NPV to the lessee is > $0. If L > $50.05 the NPV to the lessor is > $0. If L < $50.05 the NPV to the lessor is < $0. Both parties have positive NPV for $50.02 < L < $50.05. 21.7 a. Assume that 10% is the market-wide interest rate. The decision to buy or lease is made by looking at the incremental cash flows. Answers to End-of-Chapter Problems B-189 Cash flows from leasing: Year 0 1 2 3 A/T savings* $3,960 $3,960 $3,960 Lease payment -2,100 -2,100 -2,100 Tax benefit** 714 714 714 Net cash flows 2,574 2,574 2,574 * After tax savings on operations = $6,000 0.66 = $3,960 ** Tax benefit = $2,100 0.34 = $714 Cash flows from purchasing: Year 0 1 2 3 A/T savings* $5,940 $5,940 $5,940 Purchase -15,000 Dep tax 1,020 1,020 1,020 shield** Net cash flows -15,000 6,960 6,960 6,960 * After tax savings on operations = $9,000 0.66 = $5,940 ** Depreciation = $15,000 / 5 = $3,000 per annum Depreciation tax shield = $3,000 0.34 = $1,020 Incremental cash flows from leasing vs. purchasing: Year 0 1 2 3 Lease $2,574 $2,574 $2,574 Purchase -15,000 6,960 6,960 6,960 LP 15,000 -4,386 -4,386 -4,386 4 $3,960 -2,100 714 2,574 5 $3,960 -2,100 714 2,574 4 $5,940 1,020 6,960 5 $5,940 1,020 6,960 4 $2,574 6,960 -4,386 5 $2,574 6,960 -4,386 b. c. NPV of the incremental cash flows: The cash flows must be discounted at the after tax rate which is 6.6% [= 10% 0.66]. 5 NPV = $15,000 - $4,386 0.066 = $15,000 - $4,386 (4.1445) = -$3,177.78 Since the NPV of the lease-vs.-buy incremental cash flows is negative, Farmer should buy, not lease the equipment. As long as the company maintains its target debt-equity ratio, the answer does not depend upon the form of financing used for the direct purchase. A financial lease will displace debt regardless of the form of financing. The amount of displaced debt is the PV of the incremental cash flows from year one through five. PV = $4,386 (4.1445) = $18,177.78 B-190 Problems Answers to End-of-Chapter 21.8 Redwood: Cost of machine Lease payment $420,000 - L = A60.06 L L = $70,978.03 American: Cost of machine Dep tax shield A/T lease payment Year 0 -$420,000 0.65 L Year 1 - 6 $0 $21,000 0.65 L Year 7 $0 $21,000 $0 Year 0 $420,000 -L Year 1 - 6 $0 -L Year 7 $0 $0 Value of lease 7 6 = -$420,000 + $21,000 0.06( 0.65 ) + 0.65 L + 0.65 L 0.06( 0.65 ) = -$420,000 + $21,000 (6.0243) + 4.0685 L = $0 L = $72,137 The negotiating range is from $72,137 to $70,978.03. 21.9 The decision to buy or lease is made by looking at the incremental cash flows. a. Cash flow from leasing: Year 0 1 2 3 Lease payment -$1,200,000 -$1,200,000 -$1,200,000 Tax benefit* 420,000 420,000 420,000 Net cash flow -$780,000 -$780,000 -$780,000 *Tax benefit = $1,200,000 x .35 = $420,000 Cash flow from purchasing: Year 0 1 2 Purchase cost -$3,000,000 Dep tax shield* $350,000 $350,000 Net cash flow -3,000,000 350,000 350,000 *Depreciation tax shield = [$3,000,000 / 3] x 35% = $350,000 Incremental cash flows from leasing vs. purchasing: Year 0 1 Lease -$780,000 Purchase (minus) $3,000,000 -350,000 Net cash flow $3,000,000 -1,130,000 After-tax discount rate = 0.12 0.65 = 0.078 NPV of incremental cash flows 3 = $3,000,000 - $1,130,000 0.078 = $3,000,000 - $1,130,000 (2.5864) = $77,339.09 Therefore, Wolfson should lease the machine. 2 -$780,000 -350,000 -1,130,000 3 $350,000 350,000 3 -$780,000 -350,000 -1,130,000 Answers to End-of-Chapter Problems B-191 b. Wolfson is indifferent at the lease payment which makes the NPV of the incremental cash flows zero. NPV = $0 3 = $3,000,000 - (0.65 L + $350,000) 0.078 = $3,000,000 - (0.65 L + $350,000) (2.5864) L = $1,246,002.96 B-192 Problems Answers to End-of-Chapter ...
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This note was uploaded on 05/07/2010 for the course FIN 302 taught by Professor Corporationfinance during the Spring '10 term at Uni Potsdam.

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