Question

Case - 20.1. Malcolm as Tax Czar

Malcolm Middle has just been appointed the Tax Czar and is convinced that the leasing business is just a way for companies to avoid paying taxes. He has hired the Higher Consulting Firm to evaluate the cash flow effects to both the lessee and the lessor in financial leases. Mr. Middle wants to determine if there is any loss of tax revenue to the government.

The Higher Consulting Firm is using an example to analyze the taxes associated with a lease decision. The example has the following:

1. The cost of the asset is $1.25 million. The lessor will have to buy the asset to lease it to the lessee.

2. The cost of capital for both companies is 10 percent.

3. The annual cash flows (before tax) generated by the asset is $500,000, regardless of who uses the asset.

4. To acquire the asset, the company will make annual interest payments at the end of each year and

repay the principal of $1.25 million at the end of the 5th year (just like a bond).

5. Maintenance and insurance costs = $0.

6. The economic life of the asset, which is equal to the term of the lease, is 5 years.

7. Depreciation of $250,000 is claimed at the end of each year (for convenience we are assuming straight line).

8. Annual lease payments made at the end of the year are $300,000.

9. The tax rate of both lessee and lessor is 40 percent, and both companies make sufficient income to claim any tax benefits.

A. Complete the following table assuming the company buys the asset instead of leasing it.

Company Buys Asset Instead of Leasing

Year 1   Year 2   Year 3   Year 4   Year 5 Principal Repayment

Cash flow from asset

Interest payments

Lease payments

Depreciation

Tax payment

After-tax cash flows

B. Complete the following table assuming the company uses a financial lease instead of buying the asset. For simplicity, assume that the entire lease payment is treated as a financing charge (like interest).

Company Uses Financial Lease Instead of Buying (Lessee)

Year 1   Year 2   Year 3   Year 4   Year 5 Principal Repayment

Cash flow from asset

Interest payments

Lease payments

Depreciation

Tax payment

After-tax cash flows

C. Complete the following table for the lessor in the financial lease. For simplicity, assume that the entire lease payment is treated as a financing charge (like interest).

Lessor in Financial Lease

Year 1 Year 2 Year 3 Year 4 Year 5 Principal Repayment

Cash flow from asset

Interest payments

Lease payments

Depreciation

Tax payment

After-tax cash flow

D. Are Mr. Middle’s suspicions about loss of tax revenue correct?

E. How could companies gain from leasing activities? In other words, why would a lessor lease the asset to the operating company rather than use the asset itself?

Answer 1

1.Let us assume interest rate is 10% as it is not mentioned in the question

	Year 1	2	3	4	5
Cash flow from asset	5,00,000	5,00,000	5,00,000	5,00,000	5,00,000
Interest payments	125000	125000	125000	125000	125000
Lease payments	0	0	0	0	0
Depreciation	250000	250000	250000	250000	250000
Tax payment	100000	100000	100000	100000	100000
After-tax cash flows	4,00,000	400000	400000	400000	400000

year	Loan Instalment	Loan at beginning of year	Interest	principal repayment
1	3,29,728	1250000	125000	2,04,728
2	3,29,728	10,45,272	104527.2	2,25,201
3	3,29,728	8,20,071	82007.06	2,47,721
4	3,29,728	5,72,349	57234.93	2,72,493
5	3,29,728	2,99,856	29985.6	2,99,743

2.

	Year 1	2	3	4	5
Cash flow from asset	5,00,000	5,00,000	5,00,000	5,00,000	5,00,000
Interest payments
Lease payments	300000	300000	300000	300000	300000
Depreciation
Tax payment	80000	80000	80000	80000	80000
After-tax cash flows	4,20,000	4,20,000	4,20,000	4,20,000	4,20,000

3.

	Year 1	2	3	4	5
Cash flow from asset	5,00,000	5,00,000	5,00,000	5,00,000	5,00,000
Interest payments
Lease payments	300000	300000	300000	300000	300000
Depreciation	-	-	-	-	-
Tax payment	80000	80000	80000	80000	80000
After-tax cash flows	2,20,000	2,20,000	2,20,000	2,20,000	2,20,000
PV factor @10%	0.909	0.826	0.751	0.683	0.621
	199980	181720	165220	150260	136620

Principal payment will be nil

4.Yes because in case of buying more money is wasted in depreciation and interest payments due to which after tax cash flow is less.

5.Companies can gain from leasing activities because the tax which they pay due to leasing is less as compared to buying option.