Question

Introduction:

Case Study: Surgical Robot Arms Race

In the greater Seattle-Tacoma area, an arms race continues between hospitals to gather the most modern technology available to use on their patients – currently this arms race’s primary device of choice – robotic surgical systems. Why robotic surgical systems? These systems in theory allow surgeons to be more precise in performing complex surgical procedures on patients. With greater precision comes a greater chance of successfully healing the patient as well as reducing the patient’s possibility for complications and recovery time. In addition to these benefits, hospitals through the use of superior technology can serve more patients and potentially reap greater benefits from insurance companies and patients for these advanced medical services.

The price of this superior care though comes at a cost to the patient (increased charges) as well as purchase costs to the hospital. One of the most popular robotic systems is called da Vinci and is manufactured and sold by Intuitive Surgical (http://www.intuitivesurgical.com/). The da Vinci was FDA approved in July 2000 and can currently perform urologic, gynecologic, colorectal, head and neck, cardiothoracic, and other general surgery procedures. As important as the device is the surgeon that is trained in the use of the system. The more repetitions on the robotic system, the more skillful the surgeon becomes.

Depending on the options that a hospital chooses to purchase, the cost of a da Vinci system can range between 1 million and 3 million dollars with the associated sales taxes. As with all surgical instruments, there are also disposable items needed during a surgery associated with equipment – specifically the da Vinci which must also be purchased. These items range from $1,000 to $3,000. Finally, as with many pieces of sophisticated electronic technology, it must be maintained. These maintenance costs can be upwards to $200,000 a year. In addition to these specific costs, hospitals must continue to maintain the surgical suites that this equipment occupies as well as utilize all other supplies that would be used in any surgical setting.

The Deal:

A local hospital in the Puget Sound area faced a dilemma in the medical arms race. Surrounding hospitals were purchasing and utilizing the da Vinci robot system. Management began to worry about the erosion of patients that would seek out this modern technology over more traditional surgical procedures. To this end, a strategic decision was made to acquire the da Vinci robotic surgical system. The following data was presented to an analyst in the Finance Department for review:

Table 1:

Quite often, analysts are provided leasing information by the leasing company. Hospitals may choose to purchase equipment outright or acquire equipment using a lease. Leases are generally considered operating or capital leases under current accounting rules. Hospitals may purchase equipment outright if they have sufficient capital (money that can be used to purchase equipment of significant amount – usually greater than $5,000). Otherwise, they may decide that if the interest rate of payments being charged is lower than their internal cost of capital (debt financing, equity financing, etc.), they may utilize the lease directly from the equipment seller.

Lease Term:

36 Months

Lease Payment:

$68,742.10

Purchase Price:

$1,900,000.00

Page 2 of 8

Given the information provided in Table 1:

1. What is the annual rate of interest being charged to the hospital? The total interest paid over the entire term of the lease?

2. Given this rate of interest, give some reasons on why or why not the hospital should accept this lease contract. Is this a good deal for the lessee?

3. Why would a hospital care whether it was a capital lease or an operating lease? When would one be an advantage over the other?

Answer 1

There are two kinds of accounting methods for leases: operating and capital lease. A vast majority are operating leases. An operating lease is treated like renting -- payments are considered operational expenses and the asset being leased stays off the balance sheet. In contrast, a capital lease is more like a loan; the asset is treated as being owned by the lessee so it stays on the balance sheet. The accounting treatment for capital and operating leases is different, and can have a significant impact on taxes owed by the business. A capital lease is called a "finance lease".

	Capital Lease VS Operating Leases
Lease criteria - Ownership	Ownership of the asset might be transferred to the lessee at the end of the lease term.	Ownership is retained by the lessor during and after the lease term.
Lease criteria - Bargain Purchase Option	The lease contains a bargain purchase option to buy the equipment at less than fair market value.	The lease cannot contain a bargain purchase option.
Lease criteria - Term	The lease term equals or exceeds 75% of the asset's estimated useful life	The lease term is less than 75 percent of the estimated economic life of the equipment
Lease criteria - Present Value	The present value of the lease payments equals or exceeds 90% of the total original cost of the equipment.	The present value of lease payments is less than 90 percent of the equipment's fair market value
Risks and Benefits	Transferred to lessee. Lessee pays maintenance, insurance and taxes	Right to use only. Risk and benefits remain with lessor. Lessee pays maintenance costs
Accounting	Lease is considered as asset (leased asset) and liability (lease payments). Payments are shown in Balance sheet	No risk of ownership. Payments are considered as operating expenses and shown in Profit and Loss statement
Tax	Lessee is considered to be the owner of the equipment and therefore claims depreciation expense and interest expense	Lessee is considered to be renting the equipment and therefore the lease payment is considered to be a rental expense

Advantages of an operating lease

• Operating leases provide much-needed flexibility to companies that frequentlyupdate or replace their equipment.
• The lessee is protected from the risk of obsolescence.
• Accounting is simpler: the asset does not have to be included in the balance sheet. The corresponding debt liability does not have to be calculated or included either.
• Lease payments are operational expenses, so they are fully tax deductible.
• It provides improved Return On Asset (ROA) without capital budgeting restraints.

Advantages of a capital lease

• Capital leases recognize expenses sooner than equivalent operating leases. The lessee is allowed to claim depreciation each year on the asset.
• In addition to depreciation, the interest expense component of the lease payment can also be deducted as an operational expense.

The major role that plays a decider in choosing whether the person should go for the operating lease or the capital lease is determined as per the Type and Lifespan of the asset.

As mentioned above, the key thing to remember is that under an operating lease the risks and rewards of owning the asset remain with the lessor, under a finance lease these are largely transferred to the lessee.

In very general terms, if the asset has a relatively short useful lifespan within the business, before it will need to be replaced or upgraded, an operating lease might be the more commonly selected option. This is because the asset is likely to retain a significant proportion of its value at the end of the agreement and will therefore attract lower rentals during the lease period. As the lessor is taking the risk in terms of the residual value of the asset, this will be priced into the overall cost of the contract.

For assets where it is possible to influence the condition at the point of return to the lessor, and therefore give greater certainty to residual value estimates, this ‘cost of risk’ can be significantly reduced. Asset types where this is the case include cars, commercial vehicles and IT equipment.

If the asset is likely to have a longer useful life within the business, then considerations of its residual value become less critical, as this is likely to be a much smaller proportion of its original value. This may mean that the lessee is happy to take this risk in-house rather than paying a charge to the lessor for it. Here, finance lease is a more obvious choice.

As the rentals paid under a finance lease pay off all, or most, of the capital, it’s often possible to arrange a secondary rental period, and retain use of the asset, at a much reduced cost.

Period Payment Principal Part Interest Part Balance 1 $68,742.10 $40,154.83 $28,587.27 $1,859,845.17 2 $68,742.10 $40,758.99 $27,983.11 $1,819,086.18 3 $68,742.10 $41,372.25 $27,369.85 $1,777,713.93 4 $68,742.10 $41,994.73 $26,747.37 $1,735,719.20 5 $68,742.10 $42,626.58 $26,115.52 $1,693,092.61 6 $68,742.10 $43,267.94 $25,474.16 $1,649,824.67 7 $68,742.10 $43,918.95 $24,823.15 $1,605,905.72 8 $68,742.10 $44,579.75 $24,162.35 $1,561,325.98 9 $68,742.10 $45,250.49 $23,491.61 $1,516,075.48 10 $68,742.10 $45,931.33 $22,810.77 $1,470,144.15 11 $68,742.10 $46,622.41 $22,119.69 $1,423,521.74 12 $68,742.10 $47,323.89 $21,418.21 $1,376,197.86

Period Payment Principal Part Interest Part Balance 13 $68,742.10 $48,035.92 $20,706.18 $1,328,161.94 14 $68,742.10 $48,758.66 $19,983.44 $1,279,403.28 15 $68,742.10 $49,492.28 $19,249.82 $1,229,910.99 16 $68,742.10 $50,236.94 $18,505.16 $1,179,674.05 17 $68,742.10 $50,992.80 $17,749.30 $1,128,681.25 18 $68,742.10 $51,760.04 $16,982.06 $1,076,921.21 19 $68,742.10 $52,538.81 $16,203.29 $1,024,382.40 20 $68,742.10 $53,329.31 $15,412.79 $971,053.09 21 $68,742.10 $54,131.70 $14,610.40 $916,921.39 22 $68,742.10 $54,946.16 $13,795.94 $861,975.23 23 $68,742.10 $55,772.88 $12,969.22 $806,202.35 24 $68,742.10 $56,612.03 $12,130.07 $749,590.32

Period Payment Principal Part Interest Part Balance 25 $68,742.10 $57,463.81 $11,278.29 $692,126.50 26 $68,742.10 $58,328.41 $10,413.69 $633,798.09 27 $68,742.10 $59,206.02 $9,536.08 $574,592.08 28 $68,742.10 $60,096.83 $8,645.27 $514,495.25 29 $68,742.10 $61,001.04 $7,741.06 $453,494.21 30 $68,742.10 $61,918.86 $6,823.24 $391,575.35 31 $68,742.10 $62,850.48 $5,891.62 $328,724.87 32 $68,742.10 $63,796.13 $4,945.97 $264,928.74 33 $68,742.10 $64,756.00 $3,986.10 $200,172.74 34 $68,742.10 $65,730.31 $3,011.79 $134,442.43 35 $68,742.10 $66,719.29 $2,022.81 $67,723.14 36 $68,742.10 $67,723.14 $1,018.96 $0.00

Annual Interest rate=18.0551%