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 technol- ogy is changing rapidly, the actual residual value is uncertain. As an alternative to the borrow-and-buy plan, the equipment manufacturer informed Lewis that Con- solidated Leasing would be willing to write a 4-year guideline lease on the equipment, including mainte- nance, for payments of $260,000 at the beginning of each year. Lewis’ 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: 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 5 0 to t 5 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’ 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 incor- porated 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? 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? g. (1) Assume that the lease payments were actually $280,000 per year, that Consolidated Leasing is also in the 40% tax bracket, and that it also forecasts a $200,000 residual value. Also, to furnish the maintenance support, Consoli- dated 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% pre-tax return on investments of similar risk. What would be Consolidated’s NPV and IRR of leasing under these conditions? (2) What do you think the lessor’s NPV would be if the lease payment were set at $260,000 per year? (Hint: The lessor’s cash flows would be a “mirror image” of the lessee’s cash flows.) h. Lewis’ management has been considering moving to a new downtown location, and they are con- cerned that these plans may come to fruition prior to the equipment lease’s expiration. If the move occurs, then Lewis would buy or lease an entirely new set of equipment, so management would like to include a cancellation clause in the lease contract. What effect would such a clause have on the riskiness of the lease from Lewis’ standpoint? From the lessor’s standpoint? If you were the les- sor, would you insist on changing any of the other lease terms if a cancellation clause were added? Should the cancellation clause contain provi- sions similar to call premiums or any restrictive covenants and/or penalties of the type contained in bond indentures? Explain your answer.

Answer 1

a.(1)  A lease is a contractual arrangement calling for the lessee (user of the Asset) to pay the lessor (owner of the Asset) for use of an asset. Where lessee pays lease rents to the lessor in consideration of use of the Asset

(2) Types of Lease

(i) Financial Lease: This is a long term lease (generally for the period of life of Asset) and it is irrevocable. In this type of leasing the lessee has to bear all costs and the lessor does not render any service.

(ii) Operating Lease: In an operating lease, the lessee uses the asset for a specific period (generally for the period lessor the life of Asset). The lessor bears the risk of obsolescence and incidental risks. There is an option to either party to terminate the lease.

(iii) Sale & leaseback: In a sale and leaseback, a company owning the asset sells it to the lessor. The lessor pays immediately and leases the asset to the seller. Thus, the seller of the asset becomes the lessee. The asset remains with the seller who is a lessee but the ownership is with the lessor who is the buyer. This arrangement is done in case where the company having an asset is in crunch of finance for running business.

(iv) Specialized Lease: In such type of lease the lessor acquires the specialized asset for the specific lessee, in these cases asset can not be used by any other lessee and it got the characterstics of Finance lease.

(v) Cross Border Lease: Lease where both parties are from different nation

(3) Type of lease for the tax purposes:

(i) Capital Lease: In such type of lease, lease amount is capitalised the depriciated over the usefull life of the Asset

(ii) Operating Lease: These are other than Capital Lease, where lease amount is treated as operating expenses and are recorded on the profit & loss Account.

(4) Lease effect on Balance Sheet-

A capitalized lease increases the total value of the assets on your balance sheet as the amount of lease is capitalised. It will reduce your company's return on assets and its asset turnover. And since the lease also appears as a liability, it affects measures of financial leverage, such as your liabilities-to-equity ratio.

On the other hand, an operating lease doesn't appear on the balance sheet at all. Lease payments are reported as rental expenses on the income statement.

(5) Effect of Leasing on Capital Structure

Financial leasing increases a firm's financial leverage where as operating lease doesn't affect the capital structure.