Lease Essay

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CHAPTER 21 Concept Questions 4. Comment on the following remarks: a. Leasing reduces risk and can reduce a firm's cost of capital. Leasing is a form of secured borrowing. It reduces a firm’s cost of capital only if it is cheaper than other forms of secured borrowing. The reduction of uncertainty is not particularly relevant; what matters is the NAL(net advantage to leasing). b. Leasing provides 100 percent financing. The statement is not always true. For example, a lease often requires an advance lease payment or security deposit and may be implicitly secured by other assets of the firm. c. If the tax advantages of leasing were eliminated, leasing would disappear. Leasing would probably not disappear, since it does reduce the uncertainty about salvage value and the transactions costs of transferring ownership. However, the use of leasing would be greatly reduced. QUESTIONS AND PROBLEMS 7. Lease or Buy. Super Sonics Entertainment is considering buying a machine that costs $540,000. The machine will be depreciated over five years by the straight-line method and will be worthless at that time. The company can lease the machine with year-end payments of $145,000. The company can issue bonds at a 9 percent interest rate. If the corporate tax rate is 35 percent, should the company buy or lease? We will calculate cash flows from the depreciation tax shield first. The depreciation tax shield is: Depreciation tax shield = ($540,000/5)(.35) = $37,800 The aftertax cost of the lease payments will be: Aftertax lease payment = ($145,000)(1 – .35) = $94,250 So, the total cash flows from leasing are: OCF = $37,800 + 94,250 = $132,050 The aftertax cost of debt is: Aftertax debt cost = .09(1 – .35) = .0585 Using all of this information, we can calculate the NAL as: NAL = $540,000 –

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