Below is a question I encountered today which quite bothered me:
Q: A company is planning to lease new equipment for use in its manufacturing facility. Which of the following combinations of effective tax rate and restrictive bond covenants would most likely cause the company to favor an operating lease structure?
Effective tax rate Restrictive bond covenants
A. 20% NO
B. 20% YES
C. 40% NO
D. 40% YES
The answer given is B. I understand that restrictive bond covenant would cause the company to favor an operating lease over financing lease. However, can someone tell me why is the lower tax rate a factor to favor operating lease?
B gives you higher after-taxs cash flow.
It’s a weird way of looking at it.
What they really mean is that a higher tax rate favors a financing lease because your early-year expenses are higher, so a higher tax rate leads to higher taxes saved in the early years.
I was just looking over this question. I have never encountered bond covenats in relation to leases. What are they referring to here?.. the company’s debt covenat has restraints on certain kinds of leases? I have no idea why you would want one or the other.
very curious… please explain?
Leases are practically debt, more debt to an existing debt increases financial risk and default risk. Covenants set to protect bondholders may prevent the company to take leases, this is very common.
so a “restrictive” bond covenant would make you choose an operating lease over the financing lease because the financing lease is adding to liabilities and therefore inceasing risk?
d**n, this problem is all kinds of convoluted.
A common bond covenant is a minimum interest coverage ratio; interest would include interest on financial leases.
indeed it’s a little weird to look it that way, but it’ seems the only reasonable explanation. thanks