Test Bank Financial Management Theory & Practice 14th Edition Brigham

Test Bank Financial Management Theory & Practice 14th Edition Brigham Ehrhardt Complete download: https://testbankarea.com/download/test-bank-financial-management-theory-practice-1 4th-edition-brigham-ehrhardt/ Download solutions manual for Financial Management: Theory & Practice 14th Edition Brigham Ehrhardt: https://testbankarea.com/download/solutions-manual-financial-management-theory-pr actice-14th-edition-brigham-ehrhardt/ CHAPTER 19—LEASE FINANCING TRUE/FALSE 1. Many leases written today combine the features of operating and financial leases. Such leases are often called "combination leases." ANS: OBJ: STA: TOP:

T PTS: 1 DIF: Difficulty: Easy LO: 19-1 NAT: BUSPROG: Reflective Thinking DISC: Capital budgeting and cost of capital LOC: TBA Types of leases KEY: Bloom’s: Knowledge

2. A sale and leaseback arrangement is a type of financial, or capital, lease. ANS: OBJ: STA: TOP:

T PTS: 1 DIF: Difficulty: Easy LO: 19-1 NAT: BUSPROG: Reflective Thinking DISC: Capital budgeting and cost of capital LOC: TBA Types of leases KEY: Bloom’s: Knowledge

3. Operating leases help to shift the risk of obsolescence from the user to the lessor. ANS: OBJ: STA: TOP:

T PTS: 1 DIF: Difficulty: Easy LO: 19-1 NAT: BUSPROG: Reflective Thinking DISC: Capital budgeting and cost of capital LOC: TBA Operating lease KEY: Bloom’s: Knowledge

4. Under a sale and leaseback arrangement, the seller of the leased property is the lessee and the buyer is the lessor. ANS: OBJ: STA: TOP:

T PTS: 1 DIF: Difficulty: Easy LO: 19-1 NAT: BUSPROG: Reflective Thinking DISC: Capital budgeting and cost of capital LOC: TBA Sale and leaseback KEY: Bloom’s: Knowledge

5. The full amount of a lease payment is tax deductible provided the contract qualifies as a true lease under IRS guidelines. ANS: OBJ: STA: TOP:

T PTS: 1 DIF: Difficulty: Easy LO: 19-2 NAT: BUSPROG: Reflective Thinking DISC: Capital budgeting and cost of capital LOC: TBA Lease payments KEY: Bloom’s: Knowledge

6. Leasing is often referred to as off-balance sheet financing because lease payments are shown as operating expenses on a firm's income statement and, under certain conditions, leased assets and associated liabilities do not appear on the firm's balance sheet. ANS: OBJ: STA: TOP:

T PTS: 1 DIF: Difficulty: Easy LO: 19-3 NAT: BUSPROG: Reflective Thinking DISC: Capital budgeting and cost of capital LOC: TBA Off-balance sheet leasing KEY: Bloom’s: Knowledge

7. Leasing is typically a financing decision and not a capital budgeting decision. Thus, the availability of lease financing cannot affect the size of the capital budget. ANS: OBJ: STA: TOP:

F PTS: 1 DIF: Difficulty: Easy LO: 19-4 NAT: BUSPROG: Reflective Thinking DISC: Capital budgeting and cost of capital LOC: TBA Lease financing KEY: Bloom’s: Knowledge

8. A leveraged lease is more risky from the lessee's standpoint than an unleveraged lease. ANS: OBJ: STA: TOP:

F PTS: 1 DIF: Difficulty: Easy LO: 19-5 NAT: BUSPROG: Reflective Thinking DISC: Capital budgeting and cost of capital LOC: TBA Leveraged lease KEY: Bloom’s: Knowledge

9. A synthetic lease is a combination of derivative securities and asset purchases that mimic the cash flows of an operating lease. ANS: OBJ: STA: TOP:

F PTS: 1 DIF: Difficulty: Moderate LO: 19-1 NAT: BUSPROG: Reflective Thinking DISC: Capital budgeting and cost of capital LOC: TBA Synthetic leases KEY: Bloom’s: Comprehension

10. In a synthetic lease a special purpose entity (SPE) is set up by a corporation that wants to acquire the use of an asset. The SPE borrows up to 97% of its capital, uses its funds to buy the asset, and then leases it to the sponsoring corporation on a short-term basis. This keeps both the asset and the debt off the sponsoring company's books. ANS: OBJ: STA: TOP:

T PTS: 1 DIF: Difficulty: Moderate LO: 19-1 NAT: BUSPROG: Reflective Thinking DISC: Capital budgeting and cost of capital LOC: TBA Synthetic leases KEY: Bloom’s: Comprehension

11. If a leased asset has a negative residual value, for example, as a result of a statutory requirement to dispose of an asset in an environmentally sound manner, the lessee of the asset could reasonably expect to pay a lower lease rate because the asset does not have a positive residual value. ANS: OBJ: STA: TOP:

F PTS: 1 DIF: Difficulty: Moderate LO: 19-6 NAT: BUSPROG: Reflective Thinking DISC: Capital budgeting and cost of capital LOC: TBA Residual value and lease rates KEY: Bloom’s: Comprehension

12. Assume that a piece of leased equipment has a relatively high rather than low expected residual value. From the lessee's viewpoint, it might be better to own the asset rather than lease it because with a high residual value the lessee will likely face a higher lease rate.

ANS: OBJ: STA: TOP:

F PTS: 1 DIF: Difficulty: Moderate LO: 19-6 NAT: BUSPROG: Reflective Thinking DISC: Capital budgeting and cost of capital LOC: TBA Residual value and lease rates KEY: Bloom’s: Comprehension

MULTIPLE CHOICE 13. From the lessee viewpoint, the riskiness of the cash flows, with the possible exception of the residual value, is about the same as the riskiness of the lessee's a. capital budgeting project cash flows. b. debt cash flows. c. pension fund cash flows. d. sales. e. equity cash flows. ANS: OBJ: STA: TOP: MSC:

B PTS: 1 DIF: Difficulty: Easy LO: 19-4 NAT: BUSPROG: Analytic DISC: Capital budgeting and cost of capital LOC: TBA Lease cash flows KEY: Bloom’s: Comprehension TYPE: Multiple Choice: Conceptual

14. Operating leases often have terms that include a. full amortization over the life of the lease. b. very high penalties if the lease is canceled. c. restrictions on how much the leased property can be used. d. much longer lease periods than for most financial leases. e. maintenance of the equipment by the lessor. ANS: OBJ: STA: TOP: MSC:

E PTS: 1 DIF: Difficulty: Moderate LO: 19-1 NAT: BUSPROG: Analytic DISC: Capital budgeting and cost of capital LOC: TBA Operating lease KEY: Bloom’s: Analysis TYPE: Multiple Choice: Conceptual

15. Which of the following statements is most CORRECT? a. Capitalizing a lease means that the firm issues equity capital in proportion to its current capital structure, in an amount sufficient to support the lease payment obligation. b. The fixed charges associated with a lease can be as high as, but never greater than, the fixed payments associated with a loan. c. Capital, or financial, leases generally provide for maintenance by the lessor. d. A key difference between a capital lease and an operating lease is that with a capital lease, the lease payments provide the lessor with a return of the funds invested in the asset plus a return on the invested funds, whereas with an operating lease the lessor depends on the residual value to realize a full return of and on the investment. e. Firms that use "off balance sheet" financing, such as leasing, would show lower debt ratios if the effects of their leases were reflected in their financial statements. ANS: OBJ: STA: TOP: MSC:

D PTS: 1 DIF: Difficulty: Moderate LO: 19-1 NAT: BUSPROG: Analytic DISC: Capital budgeting and cost of capital LOC: TBA Leasing KEY: Bloom’s: Analysis TYPE: Multiple Choice: Conceptual

16. Financial Accounting Standards Board (FASB) Statement #13 requires that for an unqualified audit report, financial (or capital) leases must be included in the balance sheet by reporting the a. residual value as a liability. b. present value of future lease payments as an asset and also showing this same amount as an offsetting liability. c. undiscounted sum of future lease payments as an asset and as an offsetting liability. d. undiscounted sum of future lease payments, less the residual value, as an asset and as an offsetting liability. e. residual value as a fixed asset. ANS: OBJ: STA: TOP: MSC:

B PTS: 1 DIF: Difficulty: Moderate LO: 19-3 NAT: BUSPROG: Analytic DISC: Capital budgeting and cost of capital LOC: TBA Capitalizing leases KEY: Bloom’s: Analysis TYPE: Multiple Choice: Conceptual

17. Heavy use of off-balance sheet lease financing will tend to a. make a company appear less risky than it actually is because its stated debt ratio will appear lower. b. affect a company's cash flows but not its degree of risk. c. have no effect on either cash flows or risk because the cash flows are already reflected in the income statement. d. affect the lessee's cash flows but only due to tax effects. e. make a company appear more risky than it actually is because its stated debt ratio will be increased. ANS: OBJ: STA: TOP: MSC:

A PTS: 1 DIF: Difficulty: Moderate LO: 19-3 NAT: BUSPROG: Analytic DISC: Capital budgeting and cost of capital LOC: TBA Off-balance sheet leasing KEY: Bloom’s: Analysis TYPE: Multiple Choice: Conceptual

18. In the lease versus buy decision, leasing is often preferable a. because, generally, no down payment is required, and there are no indirect interest costs. b. because lease obligations do not affect the firm's risk as seen by investors. c. because the lessee owns the property at the end of the least term. d. because the lessee may have greater flexibility in abandoning the project in which the leased property is used than if the lessee bought and owned the asset. e. because it has no effect on the firm's ability to borrow to make other investments. ANS: OBJ: STA: TOP: MSC:

D PTS: 1 DIF: Difficulty: Moderate LO: 19-4 NAT: BUSPROG: Analytic DISC: Capital budgeting and cost of capital LOC: TBA Lease decision KEY: Bloom’s: Analysis TYPE: Multiple Choice: Conceptual

19. A lease versus purchase analysis should compare the cost of leasing to the cost of owning, assuming that the asset purchased a. is financed with long-term debt. b. is financed with debt whose maturity matches the term of the lease. c. is financed with a mix of debt and equity based on the firm's target capital structure, i.e., at the WACC. d. is financed with retained earnings. e. is financed with short-term debt.

ANS: OBJ: STA: TOP: MSC:

B PTS: 1 DIF: Difficulty: Moderate LO: 19-4 NAT: BUSPROG: Analytic DISC: Capital budgeting and cost of capital LOC: TBA Lease analysis discount rate KEY: Bloom’s: Analysis TYPE: Multiple Choice: Conceptual

20. Stanley Inc. must purchase $6,000,000 worth of service equipment and is weighing the merits of leasing the equipment or purchasing. The company has a zero tax rate due to tax loss carry-forwards, and is considering a 5-year, bank loan to finance the equipment. The loan has an interest rate of 10% and would be amortized over 5 years, with 5 end-of-year payments. Stanley can also lease the equipment for 5 end-of-year payments of $1,790,000 each. How much larger or smaller is the bank loan payment than the lease payment? Note: Subtract the loan payment from the lease payment. a. $177,169 b. $196,854 c. $207,215 d. $217,576 e. $228,455 ANS: C Years: Loan amount: Interest rate: Lease Pmt:

5 $6,000,000 10.0% $1,790,000 0 $6,000,000

Loan:

1 PMT

2 PMT

3 PMT

4 PMT

5 PMT

Find the loan payment: Financial calculator solution: Inputs: N = 5; I/YR = 10; PV = 6,000,000; FV = 0. Output = PMT = $1,582,785. Difference in payments = $1,790,000  $1,582,785 = $207,215. PTS: NAT: LOC: MSC:

1 DIF: Difficulty: Easy OBJ: LO: 19-4 BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital TBA TOP: Difference in payments KEY: Bloom’s: Application TYPE: Multiple Choice: Problem

21. To finance some manufacturing tools it needs for the next 3 years, Waldrop Corporation is considering a leasing arrangement. The tools will be obsolete and worthless after 3 years. The firm will depreciate the cost of the tools on a straight-line basis over their 3-year life. It can borrow $4,800,000, the purchase price, at 10% and buy the tools, or it can make 3 equal end-of-year lease payments of $2,100,000 each and lease them. The loan obtained from the bank is a 3-year simple interest loan, with interest paid at the end of the year. The firm's tax rate is 40%. Annual maintenance costs associated with ownership are estimated at $240,000, but this cost would be borne by the lessor if it leases. What is the net advantage to leasing (NAL), in thousands? (Suggestion: Delete 3 zeros from dollars and work in thousands.) a. $96 b. $106 c. $112 d. $117 e. $123 ANS: B

Years: Loan amount = equipment cost: Interest rate: Lease Pmt:

3 Tax rate: $4,800 Maintenance costs: 10.0% Salvage value: $2,100

40% $240 $0

After tax cost of debt = Rate  (1  T) = 6.0% Depreciation per year = Cost/3 = $1,600 Tax saving from deprn = Deprn  T = $640 0 Cost of owning: Interest Interest tax saving Maintenance Maintenance tax saving Deprn tax saving Repayment of loan Net cash loan costs PV cost of owning (6%): Cost of leasing: Lease payment Tax savings from lease Net cash lease costs PV cost of leasing (6%):

2

3

480 192 240 96 640

480 192 240 96 640

208

208

480 192 240 96 640 4,800 4,592

2,100 840 1,260

2,100 840 1,260

2,100 840 1,260

3,474

3,368

NAL = PV Cost of Owning  PV Cost of Leasing = PTS: NAT: LOC: MSC:

1

$106.

1 DIF: Difficulty: Moderate OBJ: LO: 19-4 BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital TBA TOP: Net advantage to leasing (NAL) KEY: Bloom’s: Analysis TYPE: Multiple Choice: Problem

22. Delamont Transport Company (DTC) is evaluating the merits of leasing versus purchasing a truck with a 4-year life that costs $40,000 and falls into the MACRS 3-year class. If the firm borrows and buys the truck, the loan rate would be 10%, and the loan would be amortized over the truck's 4-year life, so the interest expense for taxes would decline over time. The loan payments would be made at the end of each year. The truck will be used for 4 years, at the end of which time it will be sold at an estimated residual value of $10,000. If DTC buys the truck, it would purchase a maintenance contract that costs $1,000 per year, payable at the end of each year. The lease terms, which include maintenance, call for a $10,000 lease payment (4 payments total) at the beginning of each year. DTC's tax rate is 40%. What is the net advantage to leasing? (Note: Assume MACRS rates for Years 1 to 4 are 0.3333, 0.4445, 0.15, and 0.07.) a. $849 b. $896 c. $945 d. $999 e. $1,047 ANS: D Life of equipment: Loan amount = equipment cost: Interest rate:

4 Tax rate: $40,000 Maintenance costs: 10.0% Salvage value:

40% $1,000 $10,000

Lease Pmt:

$10,000

Loan amortization for cash payment and interest expense: Payment: N = 4, I/YR = 10, PV = 40000, FV = 0. PMT = $12,618.83 Year 1 2 3 4

Beg. Bal. 40,000 31,381 21,900 11,472

Loan Analysis: MACRS factor Depreciation

PMT 12,619 12,619 12,619 12,619 0

Interest 4,000 3,138 2,190 1,147 1 0.3333

Principal 8,619 9,481 10,429 11,472

Ending Bal. 31,381 21,900 11,472 0

2 0.4445 17,780

3 0.1481 5,924

4 0.0741 2,964

12,619 1,255

12,619

12,619

1,000

876 1,000

459 1,000

400 7,112

400 2,370

400 1,186

4,852

9,973

11,574

4,852

9,973

10,000 4,000 6,000 5,574

2 10,000 4,000

3 10,000 4,000

4 0 0

6,000

6,000

0

13,332 12,619

Loan Pmt Int tax saving (Int. from table  T) Maintenance

1,600 1,000

Maint. tax saving (Maint.  T)

400

Depr'n tax saving (Deprn  T)

5,333 Net operating CF

6,286

Salvage value Tax on residual Net residual val Total Net CF

6,286

PV cost of buying at I(1  T) = 6.00%

23,037

Lease Analysis: Lease payment Tax saving on pmt

0 10,000

1 10,000

4,000

4,000

6,000 22,038

6,000

Net cost of lease PV cost of leasing at I (1  T) NAL = $999 PTS: NAT: LOC: MSC:

1 DIF: Difficulty: Challenging OBJ: LO: 19-4 BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital TBA TOP: Lessee's analysis KEY: Bloom’s: Analysis TYPE: Multiple Choice: Problem

23. Carmichael Cleaners needs a new steam finishing machine that costs $100,000. The company is evaluating whether it should lease or purchase the machine. The equipment falls into the MACRS 3-year class, and it would be used for 3 years and then sold, because the firm plans to move to a new facility at that time. The estimated value of the equipment after 3 years is $30,000. A maintenance contract on the equipment would cost $3,000 per year, payable at the beginning of each year. Alternatively, the firm could lease the equipment for 3 years for a lease payment of $29,000 per year, payable at the beginning of each year. The lease would include maintenance. The firm is in the 20% tax bracket, and it could obtain a 3-year simple interest loan, interest payable at the end of the year, to purchase the equipment at a before-tax cost of 10%. If there is a positive Net Advantage to Leasing the firm will lease the equipment. Otherwise, it will buy it. What is the NAL? (Note: Assume MACRS rates for Years 1 to 4 are 0.3333, 0.4445, 0.1481, and 0.0741.) a. $5,734 b. $6,023 c. $6,324 d. $6,640 e. $6,972 ANS: A Life of equipment: Loan amount = equipment cost: Interest rate, simple: Lease Pmt: Loan Analysis: MACRS factor Depreciation

3 Tax rate: $100,000 Maintenance costs: 10.0% Salvage value: $29,000 0

1 0.3333 33,330

2 0.4445 44,550

10,000 2,000 3,000 600 6,666 3,734

10,000 2,000 3,000 600 8,890 1,490

Loan repayment Interest Int tax saving (Interest  T) Maintenance Maint. tax saving (Maint.  T) Depr'n tax saving (Deprn  T) Net operating CF Salvage value before taxes Book value (Cost  Total dep'rn) Taxable salvage value Tax on salvage value Salvage value after taxes Total Net CF PV cost at I(1  T) = 8.00%

2,400 70,306

3,734

1,510

Lease Analysis: Lease payment Tax saving on pmt Net cost of lease PV cost of leasing at I(1  T)

0 29,000 5,800 23,200 64,572

1 29,000 5,800 23,200

2 29,000 5,800 23,200

3,000 600 2,400

20% $3,000 $30,000

3 0.1418 14,180

Totals 0.9196 91,960

100,000 10,000 2,000

2,836 105,164 30,000 8,040 21,960 4,392 25,608 79,556

3 0 0

NAL = $5,734

PTS: NAT: LOC: MSC:

1 DIF: Difficulty: Challenging OBJ: LO: 19-4 BUSPROG: Analytic STA: DISC: Capital budgeting and cost of capital TBA TOP: Lessee's analysis KEY: Bloom’s: Analysis TYPE: Multiple Choice: Problem

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