Problem: 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.
Q1. 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.
Q2. 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?
Q3. Suppose the lease payments in table 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.
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 -1,745 -1,745 -1,745 -1,745 -1,745 -1,745 -1,745 -1,745 -1,745 -1,745
Lease payment tax
Credit +698 +698 +698 +698 +698 +698 +698 +698 +698 +698
Depreciation tax
credits forgone -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
Q4. 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.
Q5. 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.
Q6. 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.