Multiple Choice Questions
1. In a lease arrangement, the owner of the asset is A) the lesser. B) the lessee. C) the lessor. D) the leaser. E) None of the above.
Answer: C Difficulty: Easy Page: 593
2. In a lease arrangement, the user of the asset is A) the lesser. B) the lessee. C) the lessor. D) the leaser.
E) None of the above.
Answer: B Difficulty: Easy Page: 593
3. Which of the following would not be a characteristic of a financial lease? A) They are not usually fully amortized.
B) They usually require the lessor to maintain and insure the leased assets. C) They usually do not include a cancellation option.
D) The lessee usually has the right to renew the lease at expiration. E) All of the above are characteristics of financial leases. Answer: A Difficulty: Medium Page: 595
4. An independent leasing company supplies ___________ leases versus the manufacturer who
supplies ________________ leases. A) leveraged; direct
B) sales and leaseback; sales-type C) capital; sales-type D) direct; sales-type E) None of the above
Answer: D Difficulty: Easy Page: 594
256 Test Bank, Chapter 21
5. Which of the following is not a financial lease? A) A leveraged lease B) An operating lease C) A sale-and-leaseback D) Both A and B. E) None of the above.
Answer: B Difficulty: Easy Page: 595
6. If the lessor borrows much of the purchase price of a leased asset, the lease is called A) a leveraged lease. B) a sale-and-leaseback. C) a capital lease.
D) a nonrecourse lease. E) None of the above.
Answer: A Difficulty: Easy Page: 595
7. An operating lease's primary characteristics are
A) fully amortized, lessee maintain equipment and there is not cancellation clause. B) not fully amortized, lessor maintains equipment and there is a cancellation clause. C) fully amortized, lessor maintain equipment and there is a cancellation clause.
D) not fully amortized, lessor maintains equipment and there is not cancellation clause.
E) fully amortized, lessee maintain equipment and lessee can acquire assets at end of lease for fair
market value.
Answer: B Difficulty: Medium Page: 594
8. The city of Oakland sold city hall and some other buildings and used the proceeds to improve its
financial position. The city then leased the buildings back in order to continue to use these facilities. This is an example of A) an operating lease. B) a short-term lease. C) a sale and leaseback. D) a fully amortized lease. E) None of the above.
Answer: C Difficulty: Easy Page: 595
9. A financial lease has which as its primary characteristics
A) is fully amortized, lessee maintains equipment and there is no renewal clause and no
cancellation clause.
B) is not fully amortized, lessor maintains equipment and there is a renewal clause but no
cancellation clause.
C) is fully amortized, lessor maintains equipment and there is a renewal clause and a no
cancellation clause.
D) is not fully amortized, lessor maintains equipment and there is a renewal clause. E) is fully amortized, lessee maintains equipment and there is a renewal clause and a no
cancellation clause.
Answer: E Difficulty: Easy Page: 595
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10. An advantage of leasing is that the lessor does not own the asset and can cancel A) only financial leases. B) only operating leases. C) only capital leases. D) any kind of leases anytime. E) None of the above.
Answer: B Difficulty: Easy Page: 594
11. A leveraged lease typically involves a non-recourse loan in which A) the lessee's payments go directly to the lender in case of default. B) the lessor is not obligated in case of default. C) the third party lenders have a first lien on the assets. D) All of the above. E) None of the above.
Answer: D Difficulty: Medium Page: 595
12. For accounting purposes, which of the following conditions would automatically cause a lease to
be a capital lease? A) The lessee can purchase the asset below fair market value at the end of the lease. B) The lease transfers ownership of the asset to the lessee by the end of the lease. C) The lease term is more than 75% of the asset's economic life. D) The present value of the lease payments is more than 90% of the asset's market value at lease
inception.
E) All of the above would lead to the lease being considered a capital lease.
Answer: E Difficulty: Medium Page: 596-597
13. Capital leases would show up on the balance sheet of the firm in which manner for a six year
machinery lease worth $700,000? A) Capital leases do not have to be put on the balance sheet only financial leases do. B) Asset – Machinery $700,000; Liabilities – Long Term debt $700,000 because of debt
displacement.
C) Asset – Assets under Capital Lease $700,000; Liabilities – Obligations under Capital Lease
$700,000.
D) Assets – Assets under Capital Lease $700,000; Liabilities – Long Term Debt $700,000 because
of debt displacement.
E) None of the above.
Answer: C Difficulty: Easy Page: 596
14. Prior to FAS 13, \"Accounting for Leases\
This off-balance-sheet-financing made firms with A) capital leases appear financially stronger than firms that used debt to purchase the asset. B) operating leases appear financially stronger than firms that used debt to purchase the asset. C) lease of any type appears financially stronger than firms that used debt to purchase the asset. D) All of the above. E) None of the above.
Answer: A Difficulty: Hard Page: 596
258 Test Bank, Chapter 21
15. Which of the following is not an implication of FASB 13, Accounting for Leases? A) FASB 13 requires that the PV of the lease payments appear on the right hand side of the
balance sheet.
B) FASB 13 requires that the present value of the asset appear on the left hand side of the balance
sheet.
C) FASB 13 allows for off-balance-sheet-financing for operating leases. D) All of the above. E) None of the above.
Answer: C Difficulty: Medium Page: 596
16. The reason the IRS is most concerned about lease contracts is A) firms that lease generally pay no taxes. B) that leasing usually leads to bankruptcy. C) that leases can be set up solely to avoid taxes. D) because leasing leads to off-balance-sheet-financing. E) All of the above.
Answer: C Difficulty: Easy Page: 597
17. A lease with high payments early in its life which then decline to termination would A) provide greater cashflow to the lessee in the beginning years. B) be evidence of tax avoidance and not acceptable to the IRS. C) be qualified as a capital lease under FAS 13. D) provide a lower residual value and thus ensure a bargain-purchase price option. E) All of the above.
Answer: B Difficulty: Medium Page: 597-598
18. If a lease is for 35 years, it is regarded as a A) financial lease. B) operating lease. C) capital lease. D) conditional sale. E) sale and leaseback.
Answer: D Difficulty: Medium Page: 597
19. In valuing the lease versus purchase option, the relevant cash flows are the A) tax shield from depreciation. B) investment outlay for the equipment. C) reduction in operating costs that are not affected buy leasing. D) All of the above are irrelevant. E) None of the above are irrelevant.
Answer: D Difficulty: Medium Page: 598-599
Ross/Westerfield/Jaffe, Corporate Finance, 7/e 259
20. The appropriate discount rate for valuing a financial lease is A) the firm's after-tax weighted average cost of capital. B) the after-tax required return on assets of risks similar to the leased asset. C) the after-tax cost of secured borrowing. D) Either A or B. E) All of the above.
Answer: C Difficulty: Easy Page: 600-601
21. The WACC is not used in the lease versus purchase decision because A) the WACC was used in the decision to acquire the asset, this is only a financing decision. B) the WACC is used only when a lease alone is considered and not a lease versus purchase. C) the WACC does not include the lease cost of capital and therefore should not be used. D) tax rates of the lessor may be different than the lessee and therefore the WACC is incorrect. E) when a bank arranges a lease they do not consider the lessee's cost of capital.
Answer: A Difficulty: Hard Page: 602
22. Firms that use financial leases must consider their debt-to-equity ratios as inadequate measures of
financial leverage because A) lenders are concerned about the firm's total liabilities and related cash flow. B) debt displacement occurs with leasing. C) less future debt can be raised for a growing firm when a lease is used. D) All of the above. E) None of the above.
Answer: D Difficulty: Medium Page: 603
23. ______ would be evidence the lease is being used to avoid taxes and not a legitimate business
purpose. A) Early balloon payments B) Late balloon payments C) Capitalizing a lease D) Transfer of lease payments to a second owner E) None of the above.
Answer: A Difficulty: Medium Page: 597
24. Debt displacement is associated with leases because A) all assets not purchased with equity use debt financing. B) debt is always a cheaper source of financing and preferred to equity financing. C) FAS 13 and the IRS mandate debt displacement. D) lease financing is all debt and causes an imbalance in the optimal debt to equity ratio which
reduces future debt financing.
E) None of the above.
Answer: D Difficulty: Hard Page: 603
260 Test Bank, Chapter 21
25. A lease is likely to be most beneficial to both parties when A) the lessor's tax rate is lower than the lessee's. B) the lessor's tax rate is higher than the lessee's. C) the lessor's tax rate is equal to the lessee's. D) a lease cannot be beneficial to both parties. E) a lease always has zero NPV, so both parties always break even.
Answer: B Difficulty: Hard Page: 607
26. The price or lease payment that the lessee sets as their bound is known as A) the present value of the tax shields. B) the reservation payment, LMIN. C) the present value of operating savings. D) the reservation payment, LMAX. E) None of the above.
Answer: D Difficulty: Medium Page: 608-609
Use the following to answer questions 27-31:
Your firm is considering leasing a new computer. The lease lasts for 9 years. The lease calls for 10 payments of $1,000 per year with the first payment occurring immediately. The computer would cost $7,650 to buy and would be straight-line depreciated to a zero salvage over 9 years. The actual salvage value is negligible because of technological obsolescence. The firm can borrow at a rate of 8%. The corporate tax rate is 30%.
27. What is the after-tax cash flow from leasing relative to the after-tax cash flow from purchasing in
years 1-9? A) $- 255 B) $- 955 C) $-1,295 D) $-1,850 E) None of the above.
Answer: B Difficulty: Medium Page: 599 Rationale: $-1,000(1 - .30) -($7,650/9)(.30) = $-700 - $255 = $-955
28. What is the after-tax cash flow from leasing relative to the after-tax cash flow from purchasing in
year 0? A) $-4,865 B) $- 700 C) $6,950 D) $7,650 E) None of the above.
Answer: C Difficulty: Medium Page: 599 Rationale: $-700 - $-7,650 = $6,950
Ross/Westerfield/Jaffe, Corporate Finance, 7/e 261
29. What is the NPV of the lease relative to the purchase? A) $-1,039.78 B) $ 339.78 C) $ 360.22 D) $6,610.22 E) None of the above.
Answer: B Difficulty: Medium Page: 599 Rationale: NPV = $6,950 - $955PVIFA.056,9 = $6,950-$6,610.22 = $339.78
30. What would the after-tax cash flow in year 9 be if the asset had a residual value of $500 (ignoring
any possible risk differences)? A) $- 605 B) $- 955 C) $-1,455 D) $-1,305 E) None of the above.
Answer: D Difficulty: Hard Page: 599 Rationale: Residual + CF9 = CF9 - RV(1-TC) = $-955 - $500(1-.3) = $-955-$350 = $-1,305
31. This lease would be classified as a(n) A) operating lease because the asset will be obsolete. B) operating lease because there is not amortization. C) leveraged lease because it is being financed. D) capital lease because the lease life is greater than 75% of the economic life. E) sale and leaseback because the company gets full use of the asset.
Answer: D Difficulty: Easy Page: 597
Use the following to answer questions 32-37:
Your firm is considering leasing a new robotic milling control system. The lease lasts for 5 years. The lease calls for 6 payments of $300,000 per year with the first payment occurring at lease inception. The black box would cost $1,050,000 to buy and would be straight-line depreciated to a zero salvage. The actual salvage value is zero. The firm can borrow at 8%, and the corporate tax rate is 34%.
32. What is the appropriate discount rate for valuing the lease? A) 2.72% B) 5.28% C) 8.00% D) 12.12% E) None of the above.
Answer: B Difficulty: Medium Page: 601 Rationale: After-tax discount rate A.T. = .08(1-.34) = .0528 = 5.28%
262 Test Bank, Chapter 21
33. What is the after-tax cash flow from leasing in year 0? A) $300,000 B) $495,000 C) $852,000 D) $948,000 E) None of the above.
Answer: C Difficulty: Medium Page: 599 Rationale: $1,050,000 - $300,000(1-.34) = $1,050,000 - $198,000 = $852,000
34. What is the after-tax cash flow in years 1 through 5? A) $-126,600 B) $-198,000 C) $-269,400 D) $-287,250 E) None of the above.
Answer: C Difficulty: Medium Page: 599 Rationale: CF1 = $-300,000(1-.34) - .34($1,050,000/5) = $-198,000 - $71,400 = $-269,400
35. What is the NPV of the lease? A) $-111,690 B) $-295,040 C) $-305,388 D) $-309,690 E) None of the above.
Answer: C Difficulty: Medium Page: 602 Rationale: NPV = $852,000 $269,400(PVIFA.0528,5 ) = $852,000 $269,400(4.2962) = $852,000 - $1,157,388 =
$-305,388
36. What is the maximum lease payment that you would be willing to make? A) $170,655 B) $175,000 C) $187,842 D) $210,307 E) None of the above.
Answer: D Difficulty: Medium Page: 608-609 Rationale: LMAX = $1,050,000/PVIFAD.08,6 = $1,050,000/4.9927 = $210,307
Ross/Westerfield/Jaffe, Corporate Finance, 7/e 263
37. What is the minimum lease payment that the lessor would be willing to accept? A) $161,000 B) $176,995 C) $217,645 D) $237,083 E) None of the above.
Answer: C Difficulty: Medium Page: 609 Rationale: 0 = $-1,050,000 + (.34)($198,000)(4.2962) + .66(LMIN + 4.2962 LMIN) 0 = $-1,050,000 + $289,220 + 3.4955 L MIN LMIN = $760,680 / 3.4955 = $217,645
38. Which of the following is probably not a good reason for leasing instead of buying? A) Taxes may be reduced by leasing. B) Leasing may reduce transactions costs. C) Leasing may provide a beneficial reduction of uncertainty. D) All of the above are good reasons. E) All of the above are not good reasons.
Answer: D Difficulty: Medium Page: 607
39. Which of the following is probably a good reason for leasing instead of buying? A) Leasing provides 100% financing. B) Leasing preserves capital. C) Leasing may increase EPS relative to buying. D) All of the above are good reasons. E) None of the above is a good reason.
Answer: E Difficulty: Medium Page: 607
40. Some assets are leased more than others because A) the value of the asset under a lease is not highly affected by term of use or maintenance
decisions.
B) a lease may be used to fool clients into \"buying\" high priced assets above market value. C) leasing allows sellers to attract clients with low prices as the basis for setting the contract. D) Both A and B. E) Both A and C.
Answer: E Difficulty: Medium Page: 611
41. To meet IRS guidelines for leasing, the lease should A) limit the lessee's right to issue debt or pay dividends while the lease is operative. B) not limit the lessee's right to issue debt or pay dividends while the lease is operative. C) pay a very high return to the lessor. D) transfer ownership of the asset at the end of the lease at below fair market value. E) be over 30 years.
Answer: B Difficulty: Medium Page: 597
264 Test Bank, Chapter 21
Essay Questions
42. Sardinas Sardines has assets valued at $10 million and equity of $10 million. The firm recently
leased new equipment worth $1 million. Present the balance sheet under two conditions; the lease is judged to be an operating lease, and the lease is judged to be a capital lease. Difficulty: Easy Page: 596 Answer:
Operating: Assets $10 Million Capital = $10 Million Capital: Assets $10 Million Obligations = $1 Million Assets $1 Million Capital = $10 Million
Under Lease.
Use the following to answer questions 43-44:
The Blank Button Company is considering the purchase of a new machine for $30,000. The machine is expected to save the firm $12,500 per year in operating costs over a 5 year period, and can be depreciated on a straight-line basis to a zero salvage value over its life. Alternatively, the firm can lease the machine for $6,500 per year for 5 years, with the first payment due in 1 year. The firm's tax rate is 34%, and its cost of debt is 10%.
43. Calculate the NPV of the lease versus the purchase decision.
Difficulty: Medium Page: 602 Answer: BUY Cost After-tax Savings Dep. Tax Shield LEASE Lease Payments Tax Benefits After-tax Savings 0 $-30,000 $ 8,250 2,040 $10,290 $-6,500 2,210 8,250 $3,960 $-6,500 2,210 8,250 $3,960 1 8,250 2,040 $10,290 $-6,500 2,210 8,250 $3,960 2 8,250 2,040 $10,290 $-6,500 2,210 8,250 $3,960 3 8,250 2,040 $10,290 $-6,500 2,210 8,250 $3,960 4 8,250 2,040 $10,290 5 NPV of Lease Versus Buy: $-30,000 - ($10,290-$3,960) A5,.066 = $3,765.39 Prefer to Lease as the NPV of Lease Versus Buy is positive.
44. Calculate the reservation payment of the lessee.
Difficulty: Medium Page: 609 Answer:
LMAX = $30,000/ A5,.1 $30,000/3.79 $7,913.89
Ross/Westerfield/Jaffe, Corporate Finance, 7/e 265
266 Test Bank, Chapter 21
45. The Plastic Iron Company has decided to acquire a new electronic milling machine. Plastic Iron
can purchase the machine for $87,000 which has an expected life of 8 years and will be depreciated using 7 class MACRS rates of .1428, .2449, .1749, .125, .0892, .0892, .0892 and any remainder in year 8. Miller Leasing has offered to lease the machine to Plastic Iron for $14,000 a year for 8 years. Plastic Iron has an 18.64% cost of equity, 12% cost of debt, a 1:1 D/E ratio and faces a 34% marginal tax rate. Should they lease or buy? Show all work. Difficulty: Hard Page: 599 Answer:
Year AT Lease Payment TCDepr.
1 2 3 4 5 6 7 8 $-9,240.00 $-9,240.00 $-9,240.00 $-9,240.00 $-9,240.00 $-9,240.00 $-9,240.00 $-9,240.00 -4,224.02 -7,244.14 -5,173.54 -3,697.50 -2,638.54 -2,638.58 -2,638.54 -1,325.18 -13,464.02 -16,484.14 -14,413.54 -12,937.50 -11,878.54 -11,878.54 -11,878.54 -10,565.18
KdAT = .12(1-.34) = .12(.66) = .0792 = 7.92% Yes, the asset should be leased.
NPV =$87,000 – ($13,464.02/1.0792) – ($16,484.14/1.07922) – ($14,413.54/1.07923) –
($12,937.50/1.07924) – ($11,878.54/1.07925) – ($11,878.54/1.07926) – ($11,878.54/1.07927) – ($10,565.18/1.07928) = $87,000 – $75,976.79 = $11,023.33
Ross/Westerfield/Jaffe, Corporate Finance, 7/e 267
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