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 been asked to analyze the lease-versus-purchase decision and, in the process, to answer the following questions:

1. What is the net advantage to leasing (NAL)? Does your analysis indicate that Lewis should buy or lease the equipment? Explain.

2. 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’ lease-versus-purchase decision?

3. The lessee compares the present value of owning the equipment with the present value 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

1	What is the net advantage to leasing (NAL)? Does your analysis indicate that Lewis should buy or lease the equipment? Explain
	New Equipment Cost	1000000
	Life of the asset	4
	Residual value	200000
	Tax Rate	40%
	Loan Interest rate	10%
	Annual Rental charge	260000
	After Tax cost of debt	10%(1-.4)
		6%
	Maintenance if not leased	20000
	Calculation of Depreciation
	Depreciation rate as it is MACRS 3 yrs class		33.33%	44.45%	14.81%	7.41%
	Depreciation Expense		333300	444500	148100	74100
	Book Value at end		666700	222200	74100	0
	Schedule of the Cash Flow Statement for Buying and Leasing
	Yr	0	1	2	3	4
	Buying Option
	Equipment Cost	-1000000
	Loan Amount	1000000
	Interest Expenses		-100000	-100000	-100000	-100000
	Tax Savings from interest		40000	40000	40000	40000
	Principal Repayment					-1000000
	After Tax loan repayment		-60000	-60000	-60000	-1060000
	Depreciation-amt*40%		133320	177800	59240	29640
	Maintenance	-20000	-20000	-20000	-20000
	Tax Savings-amt*40%	8000	8000	8000	8000
	Residual value					200000
	Tax on residual value-40%					-80000
		-12000	61320	105800	-12760	-910360
	PV Factor	1	0.943	0.889	0.84	0.792
	Total PV	-12000	57825	94056	-10718	-721005
	NPV	-591842.6
	Lease Option	0	1	2	3	4
	Lease Payment	-260000	-260000	-260000	-260000
	Tax Savings from lease-40%	104000	104000	104000	104000
	Net cash flow	-156000	-156000	-156000	-156000
	PV factor @ 6%	1	0.943	0.889	0.84
	Total PV	-156000	-147108	-138684	-131040
	NPV	-572832
	There from the cost comparison it is found that leasing is having a financial advantage over buying option
	by (591842.6-572832) or $19010.6
2	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.
	Calculation of Cash Flow Statement
	Yr	0	1	2	3	4	We can use the most probable or expected cash flow --ie. (50%*0)+(50%*400000)= $ 200000 as the salvage /residual value cash flow in Year 4
	Equipment Cost	-1000000
	Loan Amount	1000000
	Interest Expense		-100000	-100000	-100000	-100000
	Tax Savings from Interest		40000	40000	40000	40000
	Principal Repayment					-1000000
	After Tax Loan Repayment		-60000	-60000	-60000	-1060000
	Depreciation		133320	177800	59240	29640
	Maintenance	-20000	-20000	-20000	-20000
	Tax Savings	8000	8000	8000	8000
	Tax on residual value					-80000
	Residual Value					200000
	PV without residual	-12000	61320	105800	-12760	-1110360
	PV factor @ 6%	1	0.943	0.889	0.84	0.792
	PV without residual	-12000	57824.76	94056.2	-10718.4	-879405.12
	PV of residual					158400
	PV without residual	-750242.56
	PV of residual	158400
	PV of ownership	-591842.56