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Financial Management: Theory and Practice

Eugene F. Brigham, Michael C. Ehrhardt

Chapter 20

Lease Financing - all with Video Answers

Educators

Chapter Questions

08:08

Problem 1

Reynolds Construction needs a piece of equipment that costs $\$ 200 .$ Reynolds either can lease the equipment or borrow $\$ 200$ from a local bank and buy the equipment. If the equipment is leased, the lease would not have to be capitalized. Reynolds's balance sheet prior to the acquisition of the equipment is as follows:
$$\begin{array}{lclr}\text { Current assets } & \$ 300 & \text { Debt } & \$ 400 \\
\text { Net fixed assets } & 500 & \text { Equity } & 400 \\
\text { Total assets } & \underline{\$ 800} & \text { Total claims } & \$ 800 \\\hline\end{array}$$
a. (1) What is Reynolds's current debt ratio?
(2) What would be the company's debt ratio if it purchased the equipment?
(3) What would be the debt ratio if the equipment were leased?
b. Would the company's financial risk be different under the leasing and purchasing alternatives?

Victoria Dollar
Victoria Dollar
Numerade Educator
05:59

Problem 2

Assume that Reynolds's tax rate is $40 \%$ and the equipment's depreciation would be $\$ 100$ per year. If the company leased the asset on a 2 -year lease, the payment would be $\$ 110$ at the beginning of each year. If Reynolds borrowed and bought, the bank would charge $10 \%$ interest on the loan. In either case, the equipment is worth nothing after 2 years and will be discarded. Should Reynolds lease or buy the equipment?

Narayan Hari
Narayan Hari
Numerade Educator
01:56

Problem 3

Two companies, Energen and Hastings Corporation, began operations with identical balance sheets. A year later, both required additional manufacturing capacity at a cost of $\$ 50,000 .$ Energen obtained a 5 -year, $\$ 50,000$ loan at an $8 \%$ interest rate from its bank. Hastings, on the other hand, decided to lease the required $\$ 50,000$ capacity for 5 years, and an $8 \%$ return was built into the lease. The balance sheet for each company, before the asset increases, follows:
a. Show the balance sheets for both firms after the asset increases and calculate each firm's new debt ratio. (Assume that the lease is not capitalized.)
b. Show how Hastings's balance sheet would look immediately after the financing if it capitalized the lease.
c. Would the rate of return (1) on assets and (2) on equity be affected by the choice of financing? How?

Nick Johnson
Nick Johnson
Numerade Educator
09:15

Problem 4

Big Sky Mining Company must install $\$ 1.5$ million of new machinery in its Nevada mine. It can obtain a bank loan for $100 \%$ of the purchase price, or it can lease the machinery. Assume that the following facts apply:
(1) The machinery falls into the MACRS 3 -year class.
(2) Under either the lease or the purchase, Big Sky must pay for insurance, property taxes, and maintenance.
(3) The firm's tax rate is $40 \%$
(4) The loan would have an interest rate of $15 \%$
(5) The lease terms call for $\$ 400,000$ payments at the end of each of the next 4 years.
(6) Assume that Big Sky Mining has no use for the machine beyond the expiration of the lease. The machine has an estimated residual value of $\$ 250,000$ at the end of the 4 th year.
What is the NAL of the lease?

Mutahar Mehkri
Mutahar Mehkri
Numerade Educator
08:16

Problem 5

Sadik Industries must install $\$ 1$ million of new machinery in its Texas plant. It can obtain a bank loan for $100 \%$ of the required amount. Alternatively, a Texas investment banking firm that represents a group of investors believes that it can arrange for a lease financing plan. Assume that these facts apply:
(1) The equipment falls in the MACRS 3 -year class.
(2) Estimated maintenance expenses are $\$ 50,000$ per year.
(3) The firm's tax rate is $34 \%$.
(4) If the money is borrowed, the bank loan will be at a rate of $14 \%$, amortized in 3 equal installments at the end of each year.
(5) The tentative lease terms call for payments of $\$ 320,000$ at the end of each year for 3 years. The lease is a guideline lease.
(6) Under the proposed lease terms, the lessee must pay for insurance, property taxes, and maintenance.
(7) Sadik must use the equipment if it is to continue in business, so it will almost certainly want to acquire the property at the end of the lease. If it does, then under the lease terms it can purchase the machinery at its fair market value at that time. The best estimate of this market value is $\$ 200,000,$ but it could be much higher or lower under certain circumstances.
To assist management in making the proper lease-versus-buy decision, you are asked to answer the following questions:
a. Assuming that the lease can be arranged, should the firm lease or borrow and buy the equipment? Explain. (Hint: In this situation, the firm plans to use the asset beyond the term of the lease. Thus, the residual value becomes a cost to leasing in Year $3 .$ The firm will depreciate the equipment it purchases under the purchase option starting in Year 3 , using the MACRS 3 -year class schedule. Depreciation will begin in the year in which the equipment is purchased, which is Year 3 .)
b. Consider the $\$ 200,000$ estimated residual value. Is it appropriate to discount it at the same rate as the other cash flows? What about the other cash flows are they all equally risky? (hint: Riskier cash flows are normally discounted at higher rates, but when the cash flows are costs rather than inflows, the normal procedure must be reversed.

Oluwadamilola Ameobi
Oluwadamilola Ameobi
Numerade Educator
08:16

Problem 6

Start with the partial model in the file $F M 12$ Ch 20 P06 Build a Model.xls at the textbook's Web site. As part of its overall plant modernization and cost reduction program, Western Fabrics' management has decided to install a new automated weaving loom. In the capital budgeting analysis of this equipment, the IRR of the project was found to be $20 \%$ versus the project's required return of $12 \%$
The loom has an invoice price of $\$ 250,000$, including delivery and installation charges. The funds needed could be borrowed from the bank through a 4 -year amortized loan at a $10 \%$ interest rate, with payments to be made at the end of each year. In the event the loom is purchased, the manufacturer will contract to maintain and service it for a fee of $\$ 20,000$ per year paid at the end of each year. The loom falls in the MACRS 5 -year class, and Western's marginal federal-plus-state $\operatorname{tax}$ rate is $40 \%$
Aubey Automation Inc., maker of the loom, has offered to lease the loom to Western for $\$ 70,000$ upon delivery and installation (at $t=0$ ) plus 4 additional annual lease payments of $\$ 70,000$ to be made at the end of Years 1 to $4 .$ (Note that there are 5 lease payments in total.) The lease agreement includes maintenance and servicing. Actually, the loom has an expected life of 8 years, at which time its expected salvage value is zero; however, after 4 years, its market value is expected to equal its book value of $\$ 42,500$. Western plans to build an entirely new plant in 4 years, so it has no interest in either leasing or owning the proposed loom for more than that period.
a. Should the loom be leased or purchased?
b. The salvage value is clearly the most uncertain cash flow in the analysis. What effect would a salvage value risk adjustment have on the analysis? (Assume that the appropriate salvage value pre-tax discount rate is $15 \% .$
c. Assuming that the after-tax cost of debt should be used to discount all anticipated cash flows, at what lease payment would the firm be indifferent to either leasing or buying?

Oluwadamilola Ameobi
Oluwadamilola Ameobi
Numerade Educator