(Leasing, taxes, and the time value of money) The lessor can claim the tax deduc

Question

(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.
1. 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.
2. 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?
3. 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.
4. 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.
5. Either find a lease rate that will give the financial lease a positive net advantage for both lessor and lessee, or show that no such lease rate exists.
6. 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.

Table 21-2 Direct cash flow consequences to NACCO of lease financing an electric shovel (amounts in thousands).

Year 0 1 2 3 4 5 6 7 8 9 10
Benefits of Leasing:
Initial outlay (avoided) +10,000
Costs of Leasing:
Lease paymentsa
-1,745 -1,745 -1,745 -1,745 -1,745 -1,745 -1,745 -1,745 -1,745 -1,745
Lease payment tax creditb
+698 +698 +698 +698 +698 +698 +698 +698 +698 +698
Depreciation tax credits forgonec
-380 -380 -380 -380 -380 -380 -380 -380 -380 -380
Salvage value forgone -500
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
aLease payments made annually in arrears.
bAssumes the lessee’s marginal income tax rate is 40%.
cAssumes straight-line depreciation to a $500,000 terminal book value for tax purposes.
Note that a different tax rate would change the cash flows. So, for example, if the firm did not expect to pay income taxes during the lease, the value of the depreciation tax deductions forgone would be zero.
Note also that in addition to the direct cash flows, leasing causes NACCO to forgo the tax deductions associated with asset ownership. We incorporate this effect later when we calculate the net advantage to leasing using the incremental cash flows.

Explanation / Answer

1) 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. 2) The following condition must hold: PV(lessee's lease payment tax shields) + PV(lessor's depreciation tax shields + other tax credits) PV(lessor's lease payment tax liability) + PV(lessee's depreciation tax shields + other tax credits) in order for a financial lease transaction to generate positive net present value benefits for lessor and lessee combined. 3) 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: NAL = 10,000,000 - sigma (1047000)/[1+(1-0.4)0.12]t - sigma (380000)/[1+(1-0.4)0.12]t - sigma (500000)/[(1+0.15)]10 => 10000000 - 7810789 - 2644460 - 123592 => $ 578841 which is more than $500,000 lower than the net advantage to leasing calculated in the text, which was -$54,236. 4) If NACC) is nontaxable, its net advantage to leasing is: NAL = 10,000,000 - sigma [1745000/(1.12)t] - sigma [500000/(1.175)10] The net advantage of the lease to the lessor is: NPVL = - 10,000,000 + sigma [1047000/(1.072)t] + sigma [380000/(1.072)t] - sigma (500000)/[(1.15)]10 = $578,841 which is smaller than NAL in absolute value. 5) A mutually advantageous lease rate, L, must satisfy the following two conditions simultaneously: NAL = 10,000,000 - sigma [L/(1.12)t] - sigma [500000/(1.175)10] > 0....=>L < 1,564,465 The two conditions cannot be satisfied simultaneously; a mutually beneficial lease rate therefore does not exist. NPVL = - 10,000,000 + sigma [0.6L/(1.072)t] + sigma [380000/(1.072)t] - sigma (500000)/[(1.15)]10 > 0 .....=> L > 1,615,681 6) Making the lease payments in advance imposes a net tax cost when the lessor pays income tax at a higher rate than the lessee.

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