Sharon McKee has been appointed finance minister and is convinced that the leasing business is just a way to avoid paying taxes. She has hired FinCorp Inc. to evaluate the cash flow effects for both the lessee and the lessor in financial leases. McKee wants to determine if there is any loss of tax revenue to the government. Use the information given below to answer the following questions.
€¢ The cost of the asset is $1.5 million. The lessor will have to buy the asset in order to lease it to lessee.
€¢ The cost of capital for both firms is 10 percent.
€¢ The annual cash flow (before tax) generated by the asset is $800,000 regardless of who uses the asset.
€¢ To acquire the asset, the firm will make annual interest payments at the end of each year and repay the principal of $1.5 million at the end of the fifth year (just like a bond).
€¢ Maintenance and insurance costs are $0.
€¢ The economic life of the asset, and the term of the lease, is five years.
€¢ A CCA of $300,000 is claimed at the end of each year (for convenience, we are assuming the firm uses the straight-line depreciation method).
€¢ Annual lease payments of $500,000 are made at the end of the year.
€¢ The tax rate of both the lessee and lessor is 40 percent.
€¢ Assume that both firms make sufficient income to claim any tax benefits.
a. Complete the following table assuming the firm buys the asset (lease payments equal 0).

b. Complete the following table assuming the firm uses a financial lease (interest payments equal 0). For simplicity, assume that the entire lease payment is treated as a financing charge (like interest).

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). The lessor borrows money to acquire the asset. The lessor will make annual interest payments at the end of each year and repay the principal of $1.5 million at the end of the fifth year (just like a bond).

d. Are Ms. McKee€™s suspicions about loss of tax revenue correct?
e. How could the firms (the sum of lessee and lessor) gain from leasing activities? In other words, why would a lessor lease the asset to the operating firm rather than use the assetitself?

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Firm buys asset Principal Year 1Year 2 Year 3Year 4Year 5 repayment Cash flow from asset Interest payments Lease payments CCA on asset Tax payment After-tax cash flows Firm uses financial lease Principal Year 1Year 2 Year 3Year 4Year 5 repayment Cash flow from asset Interest payments Lease payments CCA on asset Tax payment After-tax cash flows Lessor in financial lease Principal Year IYear 2Year 3Year 4Year 5 repayment Cash flow from asset Interest payments Lease payments CCA on asset Tax payment After-tax cash flows