Problems and Questions

1. LMN Corporation is considering leasing copier machines at a cost of \$ 500,000 a year for the next 5 years. Its income statement and balance sheet prior to the lease are as follows:
 Income Statement Balance Sheet Revenues \$ 10,000,000 Current Assets \$ 3,000,000 - Operating Expenses \$ 6,000,000 Fixed Assets \$ 7,000,000 = EBIT \$ 4,000,000 Total Assets \$ 10,000,000 - Interest Expenses \$ 1,000,000 Current Liabilities \$ 2,000,000 = Taxable Income \$ 3,000,000 Debt \$ 2,000,000 - Taxes \$ 1,200,000 Equity \$ 6,000,000 = Net Income \$ 1,800,000 Total Liabilities \$10,000,000

a. Assuming that LMN Corporation has a pre-tax cost of borrowing of 10%, estimate the effect this lease will have on the net income and balance sheet if it is treated as an operating lease.

b. Estimate the effect if the lease is treated as a capital lease, assuming that straight line depreciation will be used.

2. Using the numbers in the example above, calculate the following ratios under both the operating and capital lease assumptions:

a. Return on Capital

b. Return on Equity

c. Interest Coverage Ratio

d. Debt Ratio

3. You are comparing two retail firms, QuickShop Corporation and LoMart Corporation, which follow very different policies on leasing versus buying their retail sites. Quickshop Corporation uses operating leases to acquire retail sites and has expected lease payments of \$ 10 million for the next 10 years on its existing sites and no debt outstanding. LoMart Corporation has borrowed money to buy retail sites and has outstanding debt of \$ 50 million and an after-tax cost of debt of 5.4%. (The two firms face similar default risk and tax rates.) Assuming that the two firms have \$ 100 million in equity each, estimate

a. the debt ratio for each firm, using conventional measures of debt and equity.

b. a corrected debt ratio, which takes into account the operating leases. Which firm is more highly levered using this measure?

4. You are considering a 5-year lease of storage space, where your payments each year would amount to \$ 1 million, with the payments at the end of each year. Assuming that you have a pre-tax cost of debt is 9%, and a tax rate of 40% and that you use straight line depreciation, estimate

a. the tax deductions you would have, assuming that the lease is treated as an operating lease.

b. the tax deductions you would have, assuming that the lease is treated as a capital lease.

c. the difference in nominal and present value dollars in the tax deductions.

5. Compare the following alternatives that GMIC Inc. faces in acquiring equipment for its factories.

Alternative 1: It can buy the equipment for \$ 10 million, using a 10-year term loan at an interest rate of 10%. The equipment will be depreciated straight line over its 10-year life to a salvage value of \$ 2 million. There will be maintenance expenses of \$100,000 a year.

Alternative 2: It can lease the asset for \$1 million a year; the lessor will cover all maintenance expenses.

GMIC has a tax rate of 30% on its income.

a. Estimate the after-tax cash flows from leasing, for the next 10 years.

b. Estimate the after-tax cash flows from buying, for the next 10 years.

c. Estimate the net present values of the two options.

d. Estimate the net advantage to leasing this asset.

6. If GMIC leases the asset described above, MC Capital will be the lessor. While the purchase price, salvage value, and depreciation method are the same for both firms, MC Capital can borrow at 8% (pre-tax) and has a tax rate of 50%.

a. Estimate whether the lease makes sense from the viewpoint of MC Capital.

b. How would you explain the differences between the present value of buying the asset to GMIC and MC Capital?

7. CEF Inc. is a company that has large accumulated losses and does not expect to pay taxes for the next 5 years. It is debating whether to acquire equipment costing \$ 5 million, with a 5-year life and no salvage value. If it does so, it will borrow the purchase price at 12% and depreciate the equipment straight line over the 5-year period. DP Capital, a financing and leasing firm that can borrow at 8% and faces a 40% tax rate is willing to lease the equipment to CEF.

a. Estimate the minmium lease payment DP Capital will have to charge for this to be a viable lease.

b. Estimate the maximum lease payment CEF will be willing to pay, given its buy alternative.

8. Based on the principles of leasing developed in this chapter, explain the following phenomena:

a. Car rental companies generally lease their cars from the automobile manufacturers, rather than buy them.

b. Highly levered firms are more likely to lease assets than are firms with low leverage.

c. Large companies often lease computers rather than buying them.

d. Finance companies that often operate as lessors have high bond ratings.

9. You are looking at the financial statements of Jan Taylor Corporation, a specialty retailers of apparel. The firm leases store space and had operating lease expenses of \$ 120 million last year. These lease expenses are expected to increase 3% a year for the next five years, and then stablize at that level in the long term. The firm has no debt, but it could borrow long term at 8%; it has 100 million shares outstanding, trading at \$ 25 per share. The corporate tax rate is 40%.

a. Estimate the capitalized value of the operating lease payments.

b. Calculate the debt ratios with and without the capitalized lease payments.

10. Service International, a firm that provides data processing support to other firms, is debating whether it should buy or lease computers for its office staff. It requires 1000 computers, and the details of the two options are as follows:

• The cost per computer is \$2,000, and the aveage life of the computers is 3 years. At the end of the period, the salvage value is expected to be \$ 500 for each computer. The maintenance cost is \$ 200 each year. The computers will be depreciated straight line over the 3-year life down to the salvage value.
• The firm can lease the computers at a cost of \$ 800 a year. The lessor will maintain the computers at no cost.
• The firm can borrow money at 8% a year; its tax rate is 40%.

a. Would you buy or lease the computers?

b. What would the lease payments have to be to make leasing the better option?

11. You are debating whether to buy or lease office space for a new consulting business you plan to operate. The cost of buying the office space is \$ 200,000, and you could borrow money at 8.5%. You expect real estate to appreciate 3% a year. You could lease similar office space for \$ 2,000 a month. You will have to pay \$ 500 in maintenance costs in either scenario.

a. If you were planning to stay in business for 10 years, would you lease or buy the office space?

b. If you were uncertain about how long you would be in business, would you lease or buy the office space?

12. How would your answer to the previous problem change, if you were given the following additional information ñ

a. The lease agreement runs for three years. At the end of each 3-year period, the lease is expected to be renewed with a 7% appreciation in annual lease payments.

b. While the expected appreciation in real estate prices is 3%, there is uncertainty about this estimate resulting in an increase in the pre-tax discount rate of 2%.

13. A grocery firm, which is losing money and is in urgent need of cash, is considering selling its entire fleet of trucks and leasing them back. GE Capital has offered to buy the trucks for \$ 50 million (which is their estimated market value) and lease them back to the firm for an annual cost of \$ 4 million. The book value of the trucks is also \$ 50 million, and they can be depreciated straight line over the next ten years to a salvage value of \$ 10 million. The grocery firm has a pre-tax cost of debt of 10% and does not expect to have taxable income in the foreseeable future. Should the grocery firm do the sale and leaseback?

14. Now consider the lease from the viewpoint of GE Capital. GE Capital has a pre-tax cost of debt of 7% and faces a corporate tax rate of 40%.

a. Should it agree to buying the trucks and leasing them back?

b. How is it possible for both GE Capital and the grocery store to gain from the lease?

15. You are negotiating terms with the automobile dealer in your town, to buy a Ford Explorer. The vehicle costs \$ 30,000 and you can get a five-year term loan, with annual payments, at 8%; at the end of five years the van is expected to have a value of \$ 10,000. The dealer is willing to lease you the van for \$ 5,000 a year.

a. Assuming that the van is for personal use and that none of these payments are tax deductible, would you lease the van?

b. Would it make any difference if you were a business, and had a tax rate of 35%. (Assume that the van will be depreciated straight line over the 5-year period down to a salvage value of \$ 10,000.)

16. You are the owner of the Spokane Skins, a semi-professional football team, and you have convinced the city to grant you a 25-year lease you land to build a football stadium on, for \$ 1 million a year; you also have the option to buy the land at a bargain price at the end of the twenty fifth year. The lease will be treated as a capital lease, because of the terms involved.

a. Estimate the value of the capital lease.

b. Estimate the imputed interest payments and depreciation.