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 and, if it were purchased, Lewis could obtain a term loan for the full purchase price at a interest rate. Although the equipment has a useful life, it is classified as a special-purpose computer and therefore falls into the MACRS class. If the system were purchased, a maintenance contract could be obtained at a cost of , payable at the beginning of each year. The equipment would be sold after , and the best estimate of its residual value is . 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 guideline lease on the equipment, including maintenance, for payments of at the beginning of each year. Lewis’s marginal federal-plus-state tax rate is . You have been asked to analyze the lease-versus-purchase decision and, in the process, to answer the following questions.

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

Answer to question number e) In this case the company could end up with no money in return for the asset at the end of the term, which means the company will have no money to repay the debt owed to the equipment. If the residual value was $400,000, the company would be lucky, but there is no way to know or prepare for such a high return. In order to include this risk in the present value calculation, the company would have to calculate a risk rate and multiply it into the residual value. If the amount of ownership of the equipment is still more expensive than leasing the equipment, Lewis should remain with the lease option.

Answer to question number f) The position of the lessor is almost identical to the position of the lessee, just the mirror image. If the lessor wants to know whether leasing the equipment would be a good strategy, they should enter their information into a timeline, much like the one used to find the present values for the lessee position. If Consolidated Leasing is able to make more money by leasing the equipment, it should write the lease.