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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.

Questions:
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.

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

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.

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.

e. 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.

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

Solution Preview

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 (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)
Depriciation tax credit fargone: -380 (year 1-10)
Salvage value fargone: -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

C2. (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 ...

Solution Summary

Leasing, taxes and the time value of money is discussed.

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