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Unformatted text preview: t: 1. The lease transfers ownership of the asset by the end of the lease. In this case, the firm essentially owns the asset and will have access to its residual value. 2. The lessee can purchase the asset at a price below its fair market value (bargain purchase option) when the lease ends. The firm essentially owns the asset and will have access to most of its residual value. 3. The lease term is for 75% or more of the estimated economic life of the asset. The firm basically has access to the majority of the benefits of the asset, without any responsibility for the consequences of its disposal. 4. The present value of the lease payments is 90% or more of the fair market value of the asset at the start of the lease. The firm is essentially purchasing the asset on an installment basis. The lease must meet the following IRS standards for the lease payments to be tax deductible: 1. The lease term must be less than 80% of the economic life of the asset. If the term is longer, the lease is considered to be a conditional sale. 2. The lease should not contain a bargain purchase option, which the IRS interprets as an equity interest in the asset. 3. The lease payment schedule should not provide for very high payments early and very low payments late in the life of the lease. This would indicate that the lease is being used simply to avoid taxes. 6. 4. Renewal options should be reasonable and based on the fair market value of the asset at renewal time. This indicates that the lease is for legitimate business purposes, not tax avoidance. 7. As the term implies, off-balance sheet financing involves financing arrangements that are not required to be reported on the firm’s balance sheet. Such activities, if reported at all, appear only in the footnotes to the statements. Operating leases (those that do not meet the criteria in Question 6) provide off-balance sheet financing. For accounting purposes, total assets will be lower and some financial ratios may be artificially high. Financial analysts are generally not fooled by such practices. There are no economic consequences, since the cash flows of the firm are not affected by how the lease is treated for accounting purposes. The lessee may not be able to take advantage of the depreciation tax shield and may not be able to obtain favorable lease arrangements for “passing on” the tax shield benefits. The lessee might also need the cash flow from the sale to meet immediate needs, but will be able to meet the lease obligation cash flows in the future. Since the relevant cash flows are all aftertax, the aftertax discount rate is appropriate. 8. 9. 10. Japan Airlines’ financial position was such that the package of leasing and buying probably resulted in the overall best aftertax cost. In particular, Japan Airlines may not have been in a position to use all of its tax credits and also may not have had the credit strength to borrow and buy the plane without facing a credit downgrade and/or substantially higher rates. 11. There is the tax motive, but, beyond this, Genesis Lease Limited knows that, in the event of a default, Japan Airlines would relinquish the plane, which would then be re-leased. Fungible assets, such as planes, which can be readily reclaimed and redeployed are good candidates for leasing. 12. The plane will be re-leased to Japan Airlines or another air transportation firm, used by Genesis Lease Limited, or it will simply be sold. There is an active market for used aircraft. Solutions to Questions and Problems NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred. However, the final answer for each problem is found without rounding during any step in the problem. Basic 1. We will calculate cash flows from the depreciation tax shield first. The depreciation tax shield is: Depreciation tax shield = ($4,500,000/4)(.35) = $393,750 The aftertax cost of the lease payments will be: Aftertax lease payment = ($1,350,000)(1 – .35) = $877,500 423 So, the total cash flows from leasing are: OCF = $393,750 + 877,500 = $1,271,250 The aftertax cost of debt is: Aftertax debt cost = .08(1 – .35) = .052 Using all of this information, we can calculate the NAL as: NAL = $4,500,000 – $1,271,250(PVIFA5.20%,4) = $13,074.25 The NAL is positive so you should lease. 2. If we assume the lessor has the same cost of debt and the same tax rate, the NAL to the lessor is the negative of our company’s NAL, so: NAL = – $13,074.25 3. To find the maximum lease payment that would satisfy both the lessor and the lessee, we need to find the payment that makes the NAL equal to zero. Using the NAL equation and solving for the OCF, we find: NAL = 0 = $4,500,000 – OCF(PVIFA5.20%,4) OCF = $1,274,954.24 The OCF for this lease is composed of the depreciation tax shield cash flow, as well as the aftertax lease payment. Subtracting out...
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This note was uploaded on 07/10/2010 for the course FIN 6301 taught by Professor Eshmalwi during the Spring '10 term at University of Texas-Tyler.

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