Define each of the following terms:
a. Cumulative dividends; adjustable rate preferred stock
b. Arrearages; market auction preferred
c. Lessee; lessor
d. Sale and leaseback; operating lease; financial lease
e. Off balance sheet financing; FASB #13
f. Residual value
g. Warrant; detachable warrant; stepped-up exercise price
h. Convertible security; conversion ratio, CR; conversion price, Pc; conversion value, Ct
i. Basic EPS; primary EPS; diluted EPS
ST-2 Lease analysis The Olsen Company has decided to acquire a new truck. One alternative is to lease the truck on a 4-year contract for a lease payment of $10,000 per year, with payments to be made at the beginning of each year. The lease would include maintenance.Alternatively, Olsen could purchase the truck outright for $40,000, financing with a bank loan for the net purchase price, amortized over a 4-year period at an interest rate of 10 percent per year, payments to be made at the end of each year. Under the borrow-to-purchase arrangement, Olsen would have to maintain the truck at a cost of $1,000 per year, payable at year-end. The truck falls into the MACRS 3-year class. The applicable MACRS depreciation rates are 33, 45, 15, and 7 percent. It has a salvage value of $10,000, which is the
expected market value after 4 years, at which time Olsen plans to replace the truck irrespective of whether it leases or buys. Olsen has a federal-plus-state tax rate of 40 percent.
a. What is Olsen’s PV cost of leasing?
b. What is Olsen’s PV cost of owning? Should the truck be leased or purchased?
c. The appropriate discount rate for use in Olsen’s analysis is the firm’s after-tax cost
of debt. Why?
d. The salvage value is the least certain cash flow in the analysis. How might Olsen
incorporate the higher riskiness of this cash flow into the analysis?
