A Lease Represents a Form of Secured Debt. Each Lease Payment Includes an Interest

TABLE 21-2 Direct cash flow consequences to NACCO of lease financing an electric shovel
(amounts in thousands).
YEAR0 1 2 3 4 5 6 7 8 9 10
Benefits of Leasing:
Initial outlay (avoided) +10,000 (this is under year 0)
Costs of Leasing:
Lease payments:-1,745 (its the same from year 1 to 10)
Lease payment tax credit:+698 (year 1-10)
Depreciation tax credit forgone: -380(year 1-10)
Salvage value forgone:-500(only under year 10)
Net cash flow to lease:+10,000 -1,427 -1,427 -1,427 -1,427 -1,427 -1,427 -1,427 -1,427 -1,427 -1,927 This represents year 0 through 10

(Leasing, taxes, and the time value of money) The lessor can claim the tax deductions associated with asset ownership and realize the leased asset’s residual value. In return, the lessor must pay tax on the rental income.

a. Explain why a financial lease represents a secured loan in which the lender’s entire debt service stream is taxable as ordinary income to the lessor/lender.

A lease represents a form of secured debt. Each lease payment includes an interest

component and a principal repayment component. Because the lease payment is

taxable as ordinary income to the lessor, in

effect, the entire debt service stream (i.e., the interest component and the principal

component) is taxable as ordinary income.

b. In view of this tax cost, what tax condition must hold in order for a financial lease transaction to generate positive net-present-value tax benefits for both the lessor and lessee?

The following condition must hold:

PV(lessee's lease payment tax shields) + PV(lessor's depreciation tax shields + other tax credits)

<is greater than>

PV(lessor's lease payment tax liability) + PV(lessee's depreciation tax shields + other taxcredits) in order for a financial lease transaction to generate positive net present value benefits for lessor and lessee combined.

c. Suppose the lease payments in Table 21-2 must be made in advance, not arrears.

(Assume that the timing of the lease payment tax deductions/obligations changes
accordingly but the timing of the depreciation tax deductions does not change). Show that the net advantage to leasing for NACCO must decrease as a result. Explain why this reduction occurs.

Each after-tax lease payment is $1,047,000 (= 1,745,000 - 698,000). The net

advantage to leasing for NACCO must decrease because the lease payments

are accelerated by 1 year:

which is more than $500,000 lower than the net advantage to leasing calculated in the text, which was -$54,236.

d. Show that if NACCO is nontaxable, the net advantage to leasing is negative and greater in absolute value than the net advantage of the lease to the lessor.

If NACCO is nontaxable, its net advantage to leasing is:

The net advantage of the lease to the lessor is:

which is smaller than NAL in absolute value.

e. Either find a lease rate that will give the financial lease a positive net advantage for both lesser and lessee, or show that no such lease rate exists.

A mutually advantageous lease rate, L, must satisfy the following two conditions simultaneously:

The two conditions cannot be satisfied simultaneously; a mutually beneficial lease rate therefore does not exist.

f. Explain what your answer to part e implies about the tax costs and tax benefits of the financial lease when lease payments are made in advance.

Making the lease payments in advance imposes a net tax cost when the lessor pays income tax at a higher rate than the lessee.