Multiple Choice Questions

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C.	The term of the lease must be less than 80 percent of the economic life of the asset.

D.	The lessee should have the option to purchase the asset at a discounted price at the end of the lease term.

E.	The lessor must have a reasonable expectation of earning an aftertax profit.

Refer to section 27.3

AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 27-01 The types of leases and how the IRS qualifies leases.
Section: 27.3
Topic: Leases and the IRS

24.

The IRS will disallow any lease that:

A.	has a lease term in excess of three years.

B.	has a term that is less than one-half of the economic life of the asset.

C.	involves a lessee that has net operating losses.

D.	appears to exist solely to defer taxes.

E.	reduces the combined tax obligations of the lessor and the lessee.

Refer to section 27.3

AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 27-01 The types of leases and how the IRS qualifies leases.
Section: 27.3
Topic: Taxes and leasing

25.

The incremental cash flows of leasing consider which of the following?

I. cost of the asset

II. lease payment amount
III. applicable tax rate
IV. annual depreciation expense

A.	I and III only

B.	II and IV only

C.	II, III, and IV only

D.	I, II, and IV only

E.	I, II, III, and IV

Refer to section 27.4

AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 27-03 How to calculate the net advantage of leasing and related issues.
Section: 27.4
Topic: Incremental cash flows

26.

The relevant discount rate for evaluating a lease is the firm's:

A.	cost of equity financing.

B.	pre-tax cost of borrowing.

C.	aftertax cost of borrowing.

D.	cost of working capital.

E.	rate of return on short-term assets.

Refer to section 27.4

AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 27-03 How to calculate the net advantage of leasing and related issues.
Section: 27.4
Topic: Lease discount rate

27.

Which one of the following statements is correct concerning taxes and leasing?

A.	Tax-deferral is a legitimate reason for leasing.

B.	The lessee should be the party with the higher tax bracket.

C.	Generally speaking, lessors tend to benefit from leases while lessees do not.

D.	If a firm has significant net operating losses, it should be the lessor in a lease.

E.	You should only lease an asset if the lease will be fully amortized.

Refer to section 27.7

AACSB: Analytic
Blooms: Understand
Difficulty: 1 Easy
Learning Objective: 27-02 The reasons for leasing and the reasons for not leasing.
Section: 27.7
Topic: Taxes and leasing

28.

The most cited reason why firms enter into lease agreements is to:

A.	lower taxes.

B.	improve cash flows.

C.	reduce uncertainty.

D.	avoid balance sheet reporting.

E.	bypass restrictive loan covenants.

Refer to section 27.7

AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 27-02 The reasons for leasing and the reasons for not leasing.
Section: 27.7
Topic: Reasons for leasing

29.

Which one of the following is most likely the primary reason why a lessee opts to lease an asset on a short-term basis rather than buy that asset?

A.	keep the asset off the balance sheet

B.	tax avoidance

C.	lower total cost

D.	increased collateral

E.	nonrecourse protection

Refer to section 27.7

AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
Learning Objective: 27-02 The reasons for leasing and the reasons for not leasing.
Section: 27.7
Topic: Reasons for leasing

30.

Fred's Garage is trying to decide whether to lease or buy some new equipment. The equipment costs $48,000 and has a 6-year life. The equipment will be worthless after the 6 years and will have to be replaced. The company has a tax rate of 34 percent, a cost of borrowed funds of 7.5 percent, and uses straight-line depreciation. The equipment can be leased for $10,600 a year. What is the amount of the aftertax lease payment?

$3,286.00

$6,996.00

$7,862.55

$8,406.16

E.	$10,928.60

Aftertax lease payment = $10,600 (1 - 0.34) = $6,996

AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
Learning Objective: 27-03 How to calculate the net advantage of leasing and related issues.
Section: 27.4
Topic: Aftertax lease payment

31.

Jamestown Supply is trying to decide whether to lease or buy some new equipment. The equipment costs $72,000, has a 4-year life, and will be worthless after the 4 years. The equipment will be replaced. The cost of borrowed funds is 9 percent and the tax rate is 34 percent. The equipment can be leased for $23,800 a year. What is the amount of the aftertax lease payment?

$13,897

$14,250

$14,667

$15,708

$15,820

Aftertax lease payment = $23,800 (1 - 0.34) = $15,708

AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
Learning Objective: 27-03 How to calculate the net advantage of leasing and related issues.
Section: 27.4
Topic: Aftertax lease payment

32.

Northern Lights is trying to decide whether to lease or buy some new equipment. The equipment costs $54,000, has a 5-year life, and will be worthless after the 5 years. The company has a tax rate of 34 percent, a cost of borrowed funds of 8.75 percent, and uses straight-line depreciation. The equipment can be leased for $14,100 a year. What is the amount of the annual depreciation tax shield?

$3,672

$5,878

$6,936

$8,407

$10,200

Annual depreciation tax shield = ($54,000/5) (0.34) = $3,672

AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
Learning Objective: 27-03 How to calculate the net advantage of leasing and related issues.
Section: 27.4
Topic: SL Depreciation tax shield

33.

The Blue Goose is trying to decide whether to lease or buy some new refrigeration equipment for the restaurant. The equipment costs $63,000, has a 7-year life and will be worthless after the 7 years. The cost of borrowed funds is 8.4 percent and the tax rate is 32 percent. The equipment can be leased for $9,800 a year. What is the amount of the annual depreciation tax shield if the firm uses straight-line depreciation?

$2,880

$4,300

$7,500

$8,333

$9,000

Annual depreciation tax shield = ($63,000/7) (0.32) = $2,880

34.

Val's Pizzeria is contemplating the acquisition of some new commercial ovens. The purchase price is $39,000. The equipment will be depreciated based on MACRS depreciation which allows for 33.33 percent, 44.44 percent, 14.82 percent, and 7.41 percent depreciation over years 1 to 4, respectively. The equipment will be worthless at the end of 4 years. The equipment can be leased for $12,500 a year. The firm can borrow money at 8 percent and has a 35 percent tax rate. What is the amount of the depreciation tax shield in year 3?

$1,525.27

$1,624.50

$2,022.93

$2,325.00

$2,631.60

Year 3 depreciation tax shield = $39,000 (0.1482) (0.35) = $2,022.93

AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
Learning Objective: 27-03 How to calculate the net advantage of leasing and related issues.
Section: 27.4
Topic: MACRS depreciation tax shield

35.

Jane's Floor Care is contemplating the acquisition of some new equipment for refinishing wood floors. The purchase price is $74,000. The firm uses MACRS depreciation which allows for 33.33 percent, 44.44 percent, 14.82 percent, and 7.41 percent depreciation over years 1 to 4, respectively. The equipment can be leased for $24,600 a year. The firm can borrow money at 9.5 percent and has a 34 percent tax rate. What is the amount of the depreciation tax shield in year 4?

$1,758.09

$1,864.36

$1,940.80

$2,011.67

$2,221.08

Year 4 depreciation tax shield = $74,000 (0.0741) (0.34) = $1,864.36

36.

Steven's Auto Detailers is trying to decide whether to lease or buy some new equipment for polishing vehicles. The equipment costs $22,000, has a 3-year life, and will be worthless after the 3 years. The aftertax discount rate is 6.2 percent. The annual depreciation tax shield is $1,760 and the aftertax annual lease payment is $6,800. What is the net advantage to leasing?

-$796.58

-$397.11

$184.92

$315.40

$462.84

NAL = $22,000 - ($6,800 + $1,760) (PVIFA_{6.2%, 3}) = -$796.58

AACSB: Analytic
Blooms: Apply
Difficulty: 1 Easy
Learning Objective: 27-03 How to calculate the net advantage of leasing and related issues.
Section: 27.5
Topic: Net advantage to leasing - SL

37.

Precision Tool is trying to decide whether to lease or buy some new equipment for its tool and die operations. The equipment costs $1.2 million has a 7-year life, and will be worthless after the 7 years. The pre-tax cost of borrowed funds is 8 percent and the tax rate is 32 percent. The equipment can be leased for $242,500 a year. What is the net advantage to leasing?

-$51,566

-$34,211

$37,549

$56,828

$79,664

Aftertax lease payment = $242,500 (1 - 0.32) = $164,900
Annual depreciation tax shield = ($1,200,000/7) (0.32) = $54,857.14
Aftertax discount rate = 0.08 (1 - 0.32) = 5.44 percent
NAL = $1,200,000 - ($164,900 + $54,857.14) (PVIFA_{5.44%, 7}) = -$51,566

AACSB: Analytic
Blooms: Analyze
Difficulty: 2 Medium
Learning Objective: 27-03 How to calculate the net advantage of leasing and related issues.
Section: 27.5
Topic: Net advantage to leasing - SL

38.

Deep Mining, Inc., is contemplating the acquisition of some new equipment for controlling coal dust that costs $174,000. The firm uses MACRS depreciation which allows for 33.33 percent, 44.44 percent, 14.82 percent, and 7.41 percent depreciation over years 1 to 4, respectively. After that time, the equipment will be worthless. The equipment can be leased for $53,100 a year for 4 years. The firm can borrow money at 11.5 percent and has a 36 percent tax rate. What is the net advantage to leasing?

$5,225

$5,607

$6,611

$6,847

$6,950

After-tax lease payment = $53,100 (1 - 0.36) = $33,984
Lost depreciation tax shield year 1 = $174,000 × 0.3333 × 0.36 = $20,877.91
Lost depreciation tax shield year 2 = $174,000 × 0.4444 × 0.36 = $27,837.22
Lost depreciation tax shield year 3 = $174,000 × 0.1482 × 0.36 = $9,283.25
Lost depreciation tax shield year 4 = $174,000 × 0.0741 × 0.36 = $4,641.62
Aftertax discount rate = 0.115 (1 - 0.36) = 0.0736

39.

National Event Coordinators is contemplating the acquisition of a new tent that will be used for major outdoor events. The purchase price is $147,000. The firm uses MACRS depreciation which allows for 33.33 percent, 44.44 percent, 14.82 percent, and 7.41 percent depreciation over years 1 to 4, respectively. The tent will be worthless after four years. The tent can be leased for four years at $42,500 a year. The firm can borrow money at 7.5 percent and has a 34 percent tax rate. What is the net advantage to leasing?

$1,789

$1,862

$1,922

$2,087

$2,127

After-tax lease payment = $42,500 (1 - 0.34) = $28,050
Lost depreciation tax shield year 1 = $147,000 × 0.3333 × 0.34 = $16,658.33
Lost depreciation tax shield year 2 = $147,000 × 0.4444 × 0.34 = $22,211.11
Lost depreciation tax shield year 3 = $147,000 × 0.1482 × 0.34 = $7,407.04
Lost depreciation tax shield year 4 = $147,000 × 0.0741 × 0.34 = $3,703.52
After-tax discount rate = 0.075 (1 - 0.34) = 0.04983

40.

Baxter Contractors is evaluating the lease versus the purchase of a $329,000 machine. The machine will be depreciated using MACRS over a 4-year period, after which the machine will be worthless. MACRS allows for 33.33 percent, 44.44 percent, 14.82 percent, and 7.41 percent depreciation over years 1 to 4, respectively. The machine could be leased for $105,000 a year for 4 years. The firm can borrow money at 9.5 percent and has a 35 percent tax rate. The firm does not expect to pay any taxes for the next 5 years. What is the net advantage to leasing?

-$4,587

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