Lewis Securities Inc. has decided to acquire a new market dataand quotation system for its Richmond home office. The systemreceives current market prices and other information from severalonline data services and then either displays the information on ascreen or stores it for later retrieval by the firmâs brokers. Thesystem also permits customers to call up current quotes onterminals in the lobby.
The equipment costs $1,000,000 and, if it were purchased, Lewiscould obtain a term loan for the full purchase price at a 10%interest rate. Although the equipment has a 6-year useful life, itis classified as a special-purpose computer and therefore fallsinto the MACRS 3-year class. If the system were purchased, a 4-yearmaintenance contract could be obtained at a cost of $20,000 peryear, payable at the beginning of each year. The equipment would besold after 4 years, and the best estimate of its residual value is$200,000. However, because real-time display system technology ischanging rapidly, the actual residual value is uncertain.
As an alternative to the borrow-and-buy plan, the equipmentmanufacturer informed Lewis that Consolidated Leasing would bewilling to write a 4-year guideline lease on the equipment,including maintenance, for payments of $260,000 at the beginning ofeach year. Lewisâs marginal federal-plus-state tax rate is 40%. Youhave been asked to analyze the lease-versus-purchase decision and,in the process, to answer the following questions:
Who are the two parties to a lease transaction?
What are the five primary types of leases, and what are theircharacteristics?
How are leases classified for tax purposes?
What effect does leasing have on a firmâs balance sheet?
What effect does leasing have on a firmâs capital structure?
What is the present value of owning the equipment?(Hint: Set up a time line that shows the net cash flowsover the period to , and then find the PV of these netcash flows, or the PV cost of owning.)
Explain the rationale for the discount rate you used to find thePV.
What is Lewisâs present value of leasing the equipment?(Hint: Again, construct a time line.)
What is the net advantage to leasing (NAL)? Does your analysisindicate that Lewis should buy or lease the equipment? Explain.
Now assume that the equipmentâs residual value could be as lowas $0 or as high as $400,000, but $200,000 is the expected value.Because the residual value is riskier than the other relevant cashflows, this differential risk should be incorporated into theanalysis. Describe how this could be accomplished. (No calculationsare necessary, but explain how you would modify the analysis ifcalculations were required.) What effect would the residual valueâsincreased uncertainty have on Lewisâ lease-versus-purchasedecision?
The lessee compares the present value of owning the equipmentwith the present value of leasing it. Now put yourself in thelessorâs shoes. In a few sentences, how should you analyze thedecision to write or not to write the lease?
Lewis Securities Inc. has decided to acquire a new market dataand quotation system for its Richmond home office. The systemreceives current market prices and other information from severalonline data services and then either displays the information on ascreen or stores it for later retrieval by the firmâs brokers. Thesystem also permits customers to call up current quotes onterminals in the lobby.
The equipment costs $1,000,000 and, if it were purchased, Lewiscould obtain a term loan for the full purchase price at a 10%interest rate. Although the equipment has a 6-year useful life, itis classified as a special-purpose computer and therefore fallsinto the MACRS 3-year class. If the system were purchased, a 4-yearmaintenance contract could be obtained at a cost of $20,000 peryear, payable at the beginning of each year. The equipment would besold after 4 years, and the best estimate of its residual value is$200,000. However, because real-time display system technology ischanging rapidly, the actual residual value is uncertain.
As an alternative to the borrow-and-buy plan, the equipmentmanufacturer informed Lewis that Consolidated Leasing would bewilling to write a 4-year guideline lease on the equipment,including maintenance, for payments of $260,000 at the beginning ofeach year. Lewisâs marginal federal-plus-state tax rate is 40%. Youhave been asked to analyze the lease-versus-purchase decision and,in the process, to answer the following questions:
Who are the two parties to a lease transaction?
What are the five primary types of leases, and what are theircharacteristics?
How are leases classified for tax purposes?
What effect does leasing have on a firmâs balance sheet?
What effect does leasing have on a firmâs capital structure?
What is the present value of owning the equipment?(Hint: Set up a time line that shows the net cash flowsover the period to , and then find the PV of these netcash flows, or the PV cost of owning.)
Explain the rationale for the discount rate you used to find thePV.
What is Lewisâs present value of leasing the equipment?(Hint: Again, construct a time line.)
What is the net advantage to leasing (NAL)? Does your analysisindicate that Lewis should buy or lease the equipment? Explain.
Now assume that the equipmentâs residual value could be as lowas $0 or as high as $400,000, but $200,000 is the expected value.Because the residual value is riskier than the other relevant cashflows, this differential risk should be incorporated into theanalysis. Describe how this could be accomplished. (No calculationsare necessary, but explain how you would modify the analysis ifcalculations were required.) What effect would the residual valueâsincreased uncertainty have on Lewisâ lease-versus-purchasedecision?
The lessee compares the present value of owning the equipmentwith the present value of leasing it. Now put yourself in thelessorâs shoes. In a few sentences, how should you analyze thedecision to write or not to write the lease?
