Question

Lewis Health System Inc. has decided to acquire a new electronic health record system for its Richmond hospital. The system receives clinical data and other patient information from nursing units and other patient care areas, then either displays the information on a screen or stores it for later retrieval by physicians. The system also permits patients to call up their health record on Lewis's website. 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 percent interest rate. Although the equipment has a six-year useful life, it is classified as a special-purpose computer, so it falls into the MACRS three-year class. If the system were purchased, a four-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 four years, and the best estimate of its residual value at that time is $200,000. However, since 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 four-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 percent. You have been asked to analyze the lease-versus-purchase decision, and in the process to answer the following questions:

a. What is the present value cost of owning the equipment?

b. What is the present value cost of leasing the equipment?

c. What is the net advantage to leasing (NAL)?

d. Answer these questions one at a time to see the effect of the change on NAL. That is, starting with the original numbers you used for questions a. and b., what is the NAL if: - interest rate increases to 12 percent - the tax rate falls to 34 percent - maintenance cost increases to $25,000 per year - residual value falls to $150,000 - the system price increases to $1,050,000

e. Do the changes in d. make leasing more or less attractive? Explain.

I HAVE ANSWERS A - C, JUST NEED HELP WITH D. PLEASE SHOW ALL STEPS FOR D, YOU WILL RECEIVE THUMBS UP

Answer 1

Input Data
(all dollar figures in thousands)
New Equipment cost		$1,000		KEY OUTPUT
New Equipment life		4
Equip. Residual Value		$200		LEASE
Tax Rate		40%		because the net advantage of leasing is				$18.80
Loan interest rate		10%
Annual rental charge		$260
After-tax cost of debt		6%
Maintenance if not leased		$20
NPV LEASE ANALYSIS
Depreciation Rate			33.33%	44.45%	14.81%	7.41%
Depreciation Expense			333.30	444.50	148.10	74.10
BV at end of year			666.70	222.20	74.10	-
	Year =	0	1	2	3	4
Cost of Owning
Equipment cost		($1,000)
Loan amount		$1,000
Interest expense			($100)	($100)	($100)	($100)
Tax savings from interest			40	40	40	40
Principal repayment						($1,000)
After tax loan payment			($60)	($60)	($60)	($1,060)
Depreciation shield			$133.320	$177.800	$59.240	$29.640
Maintenance		($20)	($20)	($20)	($20)
Tax savings on maintenance		$8	$8	$8	$8	$0
Residual value						$200
Tax on residual value						($80)
Net cash flow		($12.000)	$61.320	$105.800	($12.760)	($910.360)
PV ownership cost @ 6%		($591.793)
(2) Explain the rationale for the discount rate you used to find the PV.
Leasing is similar to debt financing in that the cash flows have relatively low risk because most are fixed by contract. Therefore the firms 10% cost of debt is a good start. The tax shield of interest payments must be considered. 10%(1 - T) = 10%(1 - 0.4) = 6.0%.
									c. What is Lewis's present value cost of leasing the equipment? (Hint: Again, construct a time line.)
	Year =	0	1	2	3	4
Cost of Leasing
Lease payment		($260)	($260)	($260)	($260)
Tax savings from lease		$104	$104	$104	$104
Net cash flow		($156)	($156)	($156)	($156)	$0
PV of leasing @ 6%		($572.990)
d. What is the net advantage to leasing (NAL)? Does your analysis indicate that Lewis should buy or lease the equipment? Explain.
Cost Comparison
PV of leasing @ 6%		($572.990)
PV ownership cost @ 6%		($591.793)
Net Advantage to Leasing		$18.803
e. Now assume that the equipment's residual value could be as low as $0 or as high as $400,000, but that $200,000 is the expected value. Since the residual value is riskier than the other cash flows in the analysis, 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 increased uncertainty about the residual value have on Lewis's lease-versus-purchase decision?
									The discount rate applied to the residual value inflow (a positive CF) should be increased to account for the increased risk. If the residual value were included as an outflow (a negative CF) in the cost of leasing cash flows, the increased risk would be reflected by applying a lower discount rate to the residual value cash flow. All other cash flows should be discounted at the original 6% rate.
																		Alter the Residual Discount Rate to see the effect on PV
	Year =	0	1	2	3	4
Cost of Owning
Equipment cost		($1,000)
Loan amount		$1,000
Interest expense			($100)	($100)	($100)	($100)
Tax savings from interest			$40	$40	$40	$40
Principal repayment						($1,000)
After tax loan payment			($60)	($60)	($60)	($1,060)
Depreciation shield			$133.320	$180.000	$60.000	$28.000
Maintenance		($20)	($20)	($20)	($20)
Tax savings on maintenance		$8	$8	$8	$8
Tax on residual value						($80)
Cash flow without residual		$          (12)	$         61	$          108	$          (12)	$      (1,112)
Residual cash flow			$           -	$              -	$             -	$200
PV minus residual @ 6%		$    (748.91)
PV of residual @	6%	$158.42
PV of ownership		$    (590.50)		Residual Discount Rate		6.00%
The lessor owns the equipment when the lease expires. Therefore, residual value risk is passed from the lessee to the lessor. The increased residual value risk makes the lease more attractive to the lessee.
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 write the lease?
To the lessor, writing the lease is an investment. Therefore, the lessor must compare the return on the lease investment with the return available on alternative investments of similar risk.
g. (1) Assume that the lease payments were actually $280,000 per year, that Consolidated Leasing is also in the 40 percent tax bracket, and that it also forecasts a $200,000 residual value. Also, to furnish the maintenance support, Consolidated would have to purchase a maintenance contract from the manufacturer at the same $20,000 annual cost, again paid in advance. Consolidated Leasing can obtain an expected 10 percent pre-tax return on investments of similar risk. What would Consolidated's NPV and IRR of leasing be under these conditions?
									NPV LEASOR'S ANALYSIS
									Lease payment =		$280
									Lessor's tax rate =		40%
Lessor's pre-tax interest rate =		10%
After-tax discount rate =		6.00%
	Year =	0	1	2	3	4
Cost of Owning
Equipment cost		($1,000)
Depreciation shield			$133.320	$177.800	$59.240	$29.640
Maintenance		($20)	($20)	($20)	($20)
Tax savings on maintenance		$8	$8	$8	$8
Lease payment		$280	$280	$280	$280
Tax on lease payment		($112)	($112)	($112)	($112)
Residual value						$200
Tax on residual value						($80.000)
Net cash flow		($844.000)	$289.320	$333.800	$215.240	$149.640
	PV @ 6%	$25.273
	IRR	7.46%
(2) What do you think the lessor's NPV would be if the lease payments were set at $260,000 per year? (Hint: The lessor's cash flows would be a "mirror image" of the lessee's cash flows.)
With lease payments of $260,000, the lessor’s cash flows would be equal, but opposite in sign, to the lessee’s NAL.
Thus, lessor’s NPV =		(18,803)
If all inputs are symmetrical, leasing is a zero-sum game.
h. Lewis's management has been considering moving to a new downtown location, and they are concerned that these plans may come to fruition prior to the expiration of the lease. If the move occurs, Lewis would buy or lease an entirely new set of equipment, and hence management would like to include a cancellation clause in the lease contract. What impact would such a clause have on the riskiness of the lease from Lewis's standpoint? From the lessor's standpoint? If you were the lessor, would you insist on changing any of the lease terms if a cancellation clause were added? Should the cancellation clause contain any restrictive covenants and/or penalties of the type contained in bond indentures or provisions similar to call premiums?
									A cancellation clause would lower the risk of the lease to the lessee but raise the lessor’s risk. To account for this, the lessor would increase the annual lease payment or else impose a penalty for early cancellation.