Question

Lewis Securities Inc. has decided to acquire a new market data and quotation system for
its Richmond home office. The system receives current market prices and other information
from several online data services and then either displays the information on a screen
or stores it for later retrieval by the firm’s brokers. The system also permits customers to
call up current quotes on terminals in the lobby.
The equipment costs $1,000,000 and, if it were purchased, Lewis could obtain a term
loan for the full purchase price at a 10% interest rate. Although the equipment has a 6-
year useful life, it is classified as a special-purpose computer and therefore falls into the
MACRS 3-year class. If the system were purchased, a 4-year maintenance contract could
be obtained at a cost of $20,000 per year, payable at the beginning of each year. The
equipment would be sold after 4 years, and the best estimate of its residual value is
$200,000. However, because real-time display system technology is changing rapidly, the
actual residual value is uncertain.
As an alternative to the borrow-and-buy plan, the equipment manufacturer
informed Lewis that Consolidated Leasing would be willing to write a 4-year guideline
lease on the equipment, including maintenance, for payments of $260,000 at the
beginning of each year. Lewis’s marginal federal-plus-state tax rate is 40%. You have
Build a Model:
Lessee’s Analysis
You have been asked to analyze the lease-versus-purchase decision and, in the process, to
answer the following questions.
a. (1) Who are the two parties to a lease transaction?
(2) What are the five primary types of leases, and what are their characteristics?
(3) How are leases classified for tax purposes?
(4) What effect does leasing have on a firm’s balance sheet?
(5) What effect does leasing have on a firm’s capital structure?
b. (1) What is the present value cost of owning the equipment? (Hint: Set up a time line
that shows the net cash flows over the period t = 0 to t = 4, and then find the PV
of these net cash flows, or the PV cost of owning.)
(2) Explain the rationale for the discount rate you used to find the PV.
c. What is Lewis’s present value cost of leasing the equipment? (Hint: Again, construct a
time line.)
d. What is the net advantage to leasing (NAL)? Does your analysis indicate that Lewis
should buy or lease the equipment? Explain.
e. Now assume that the equipment’s residual value could be as low as $0 or as high as
$400,000, but $200,000 is the expected value. Because the residual value is riskier than
the other relevant cash flows, this differential risk should be incorporated into the
analysis. Describe how this could be accomplished. (No calculations are necessary, but
explain how you would modify the analysis if calculations were required.) What effect
would the residual value’s increased uncertainty have on Lewis’s lease-versuspurchase
decision?
f. The lessee compares the cost of owning the equipment with the cost of leasing it. Now
put yourself in the lessor’s shoes. In a few sentences, how should you analyze the
decision to write or not to write the lease?

Answer 1

a)

1)Parties to lease contract are the lessee, who uses the asset, and the lessor, who owns the asset.

2)The five primary types of leases are operating, financial, sale and leaseback, combination, and synthetic. An operating lease, sometimes called a service lease, provides for both financing and maintenance. Generally, the operating lease contract is written for a period considerably shorter than the expected life of the leased equipment, and contains a cancellation clause. A financial lease does not provide for maintenance service, is not cancelable, and is fully amortized; that is, the lease covers the entire expected life of the equipment. In a sale and leaseback arrangement, the firm owning the property sells it to another firm, often a financial institution, while simultaneously entering into an agreement to lease the prop­erty back from the firm. A sale and leaseback can be thought of as a type of financial lease. A combination lease combines some aspects of both operating and financial leases. For example, a financial lease which contains a cancellation clause--normally associated with operating leases--is a combination lease. In a leveraged lease, the lessor borrows a portion of the funds needed to buy the equipment to be leased. A synthetic lease is created when a company creates a special purpose entity (SPE) that borrows and then purchases an asset (usually a long-term asset) and leases it back to the company. The company guarantees the SPE’s debt, and enters into an operating lease with it. This arrangement has been used to avoid capitalizing the lease and therefore reporting it as a liability. Although the company has a liability it has guaranteed the SPE’s debt it doesn’t report the liability. And since the lease is an operating lease, it doesn’t capitalize it and report the lease payments as a liability and the asset as an asset. Therefore, the transaction may leave no evidence on the balance sheet

3)A guideline lease is a lease that meets all of the IRS requirements for a genuine lease. A guideline lease is often called a tax-oriented lease. If a lease meets the IRS guidelines, the IRS allows the lessor to deduct the asset’s depreciation and allows the lessee to deduct the lease payments.

4)If the lease is classified as a capital lease, it is shown directly on the balance sheet. If it is an operating lease, it is only listed in the footnotes.

5)Leasing is a substitute for debt financing, so leasing increases a firm’s financial leverage.

b)

1)

To develop the cost of owning, we begin by constructing the depreciation schedule: depreciable basis = $1,000,000.

MACRS Depreciation End-Of-Year

                 Year            Rate                Expense Book Value

                   1                0.33                    $ 330,000 $670,000

2 0.45                        450,000 220,000

3                0.15                        150,000 70,000

4                0.07                          70,000 0

1.00                   $1,000,000

Cost Of Owning Time Line:

0                  1                2                  3                     4

  

AT Loan Payment                                -60,000       -60,000       -60,000       -1,060,000

Dep. Tax Savings 132,000       180,000         60,000             28,000

Maintenance (AT) -12,000       -12,000       -12,000       -12,000                       

Res. Value (AT)   _______      _______      _______      _______           120,000

Net Cash Flow                  -12,000        60,000       108,000       -12,000        -912,000

Depreciation is a tax-deductible expense, so it produces a tax savings of t(depreciation). For example, the savings in year 1 is 0.4($330,000) = $132,000.

Each maintenance expense is $20,000, but it is tax deductible, so the after-tax flow is (1 - t)$20,000 = $12,000.

The ending book value is $0, so taxes must be paid on the full $200,000 salvage (residual) value.

PV cost of owning (@6%) = $591,741.

2)

The proper discount rate depends on

(1) the riskiness of the cash flow stream and

(2) the general level of interest rates.

The loan payments and the maintenance costs are fixed by contract, hence are not at all risky. The depreciation deductions are also “locked in,” but the tax rate could change. Thus, depreciation cash flows (tax savings) are not totally certain, but they are relatively certain. Only the residual value is highly uncertain. On balance, and in relation to cash flows associated with such activities as capital budgeting, we conclude that the cash flows in the time line are relatively safe, so they should be discounted at a relatively low rate. In fact, they have about the same degree of riskiness as the firm’s debt cash flows. Therefore, we conclude that leasing has about the same impact on the firm’s financial risk as debt financing, so the appropriate discount rate is Lewis’s cost of debt. Further, since the cash flows are stated on an after-tax basis, the rate should be the after-tax cost of debt. Lewis’s before-tax debt cost is 10 percent, and since the firm is in the 40 percent tax bracket, its after-tax cost is 10.0%(1 - 0.40) = 6.0%. Therefore, we use 6 percent as the discount rate.

c)

If Lewis leased the equipment, its only cash flows would be the after-tax lease payments:

0                   1                   2                   3                   4

  

Lease Pmt. (AT)   -156,000       -156,000       -156,000       -156,000

Each lease payment is $260,000, but this is deductible, so the after-tax cost of the lease is (1 - t)($260,000) = $156,000.

PV cost of leasing (@6%) = $572,990

d)

The net advantage to leasing (NAL) is $18,751:

             NAL= PV Cost Of Owning - PV Cost Of Leasing

                                  = $591,741 - $572,990 = $18,751.

The NAL is positive, which indicates that the PV cost of owning is greater. Therefore, leasing is less expensive than borrowing and buying, so Lewis should lease the equipment rather than purchase it

e)First, note that the residual value in a lease analysis will be shown either in the “cost of owning section” or in the “cost of leasing” section, depending on whether or not the company plans to continue using the leased asset at the expiration of the basic lease.   If the lessee plans to continue using the equipment, then it will have to be purchased when the lease expires, and in this case the residual value appears as a cost in the leasing cost section. However, if the lessee plans not to continue using the equipment, then the residual value will not be shown in the leasing section-rather, it will be shown as an inflow in the cost of owning section. In Lewis’s case, the asset will not be needed at the expiration of the lease, so the residual is shown as an inflow in the owning section. In this situation, we account for increased risk by increasing the rate used to discount the residual value cash flow, resulting in a lower present value of the residual cash flow. This leads to a higher cost of owning, so the greater the risk of the residual value, the higher the cost of owning, and the more attractive leasing becomes.

Note, though, that the situation would be different if Lewis planned to lease and then exercise a fair market value purchase option in order to continue using the equipment. Then the residual would be shown as a cost in the leasing section, and its higher risk would be reflected by discounting it at a lower rate. In that situation the riskiness of the residual would penalize rather than help the lease.

In the case at hand, the lessor, not the lessee, will own the asset at the end of the lease, so the lessor bears the residual value risk. In effect, the lease transaction passes the risk associated with the residual value from the lessee/user to the lessor. Of course, the lessor recognizes this, and as a result, assets with highly uncertain residual values will carry higher lease payments than assets with relatively certain residual values. However, the most successful leasing companies have developed expertise in renovating and disposing of used equipment, and this gives them an advantage over most lessees in reducing residual value risks.

Further, leasing companies usually deal with a wide array of assets, so residual value estimates that are too high on one asset may be offset by estimates that are too low on another.

f)The lessor should view “writing” the lease as an investment, so the lessor should compare the return on the lease with returns available on alternative investments of similar risk.