CFA Practice Question

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CFA Practice Question

Which of the following is a factor that would cause a firm not to use capital leases?

A. High effective tax rates
B. Lease terms equal to the life of the asset
C. A high level of debt
Correct Answer: C

If a firm has a high level of debt already, adding a capital lease will increase its debt, which could affect the debt ratios unfavorably.

User Contributed Comments 7

User Comment
stranger a. high effective rates means borrowing is expensive and PV of capital lease is lower: firm wud use CL b. firm wud use: better option than borrowing c. less debt: firm wud add CL, adding some more debt d. THIS IS UNFAVORABLE HENCE FIRM WUD NOT USE CL
kalps High effective tax rate means that operating lease payments would reduce profits and therefore tax - which is also positive.

However the answer is also correct in that gearing will increase with higher debt as the capital lease is effectively put on the balance sheet as debt
Gina why does a high effective tax rate increase the cost of borrowing?
mtcfa My take on the high effective tax rates is that a firm would prefer a capital lease because, in addittion to the interest expense, the firm can also deduct depreciation, and at least save in taxes in the early years. I'm not sure it has anything to do with the cost of borrowing.
gill15 High effective tax rates --- What does this mean? We want low Pretax Income to be taxed. How do we accomplish this? We would want own the items and have them depreciate ---

High effective tax rates --- want depreciation X to lower our profits --- need a capital lease.
gill15 Also from the borrowers end -- High effective tax rate would mean high borrowing from the bank, so get a capital lease from the lessor at a lower rate.
Shaan23 What I didnt understand was who the firm is(Lessee or the Lessor). Depending on who it is the answer is different.
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