Leasing, taxes, and the time value of money - 22285

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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 assetÂ’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 lenderÂ’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 question 5 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) IN ORDER: YEAR 0 1 2 3 4 5 6 7 8 9 10 Benefits of Leasing: Initial outlay (avoided) +10,000 Costs of Leasing: Lease payments(a) −1,745 −1,745 −1,745 −1,745 −1,745 −1,745 −1,745 −1,745 −1,745 −1,745 Lease payment tax credit(b) +698 +698 +698 +698 +698 +698 +698 +698 +698 +698 Depreciation tax credits forgone(c) −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 (a)Lease payments made annually in arrears) (b)Assumes the lesseeÂ’s marginal income tax rate is 40%) (c)Assumes straight-line depreciation to a $500,000 terminal book value for tax purposes)

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