(Leasing, taxes, and the time value of money) The lessor can claimthe tax deductions associated with asset ownership and realize theleased asset's residual

value. In return, the lessor must pay tax on the rentalincome.

1. Explain why a financial lease represents a secured loan in whichthe lender's entire debt service stream is taxable as ordinaryincome to the lessor/lender.

2. In view of this tax cost, what tax condition must hold in orderfor a financial lease transaction to generate positivenet-present-value tax benefits for both the lessor andlessee?

3. Suppose the lease payments in Table 21-2 must be made inadvance, not arrears. (Assume that the timing of the lease paymenttax deductions/obligations changes accordingly but the timing ofthe depreciation tax deductions does not change). Show that the netadvantage to leasing for NACCO must decrease as a result. Explainwhy this reduction occurs.

4. Show that if NACCO is nontaxable, the net advantage to leasingis negative and greater in absolute value than the net advantage ofthe lease to the lessor.

5. Either find a lease rate that will give the financial lease apositive net advantage for both lessor and lessee, or show that nosuch lease rate exists.

6. Explain what your answer to part e implies about the tax costsand tax benefits of the financial lease when lease payments aremade in advance.

Table 21-2 Direct cash flow consequences to NACCO of leasefinancing 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 bookvalue for tax purposes.

Note that a different tax rate would change the cash flows. So, forexample, if the firm did not expect to pay income taxes during thelease, the value of the depreciation tax deductions forgone wouldbe zero.

Note also that in addition to the direct cash flows, leasing causesNACCO to forgo the tax deductions associated with asset ownership.We incorporate this effect later when we calculate the netadvantage to leasing using the incremental cash flows.