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. 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?

2. 1. What is the present value of owning the equipment? (Hint: Set up a time line that shows the net cash flows over the period  to , 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.

3. What is Lewis’s present value of leasing the equipment? (Hint: Again, construct a time line.)

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

5. 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?

6. 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. Who are the two parties to a lease transaction?

Answer: The two parties are the lessor (the one who owns the asset) and lessee (the one who uses the asset).

2. What are the five primary types of leases, and what are their characteristics?

Answer: Leases are classified as operating, financial, sale and leaseback, combination and synthetic. Operating lease also known as service lease, is a lease where the asset is financed as well as maintained by the lessor. The duration of such lease is short and allows the lessee to cancel the contract anytime. A financial or capital lease is neither financed nor maintained by lessor, neither provides for cancellation. This is because the duration of lease is almost for the life of the asset. A sale and leaseback agreement, allows the lessee to own the asset and sell it to third party (mostly financial institution) and simultaneously lease the asset back to the firm. It is a type of financial lease. A combination lease includes features of both operating and financial lease. For instance, a financial lease that provides the option to cancel the contract is a combined lease. Under leveraged lease, the lessor borrows some portion of the funds needed to purchase the asset that is to be leased. A synthetic lease is generated when a company that borrows and then purchases the asset so as to lease it back to the seller. Here, the purchaser guarantees the debt and creates an operating lease. In such a situation, the asset is not capitalized and is rather shown as a liability. Though the company guarantees the asset but it is not a liability and as it is been leased out, the lease payments cannot be reported as a liability. Further the asset cannot be shown as an asset. Thus, such a contract is often shown in the notes to the company’s financial statements.

3. How are leases classified for tax purposes?

Answer: The lease that meets all the requirements of IRS is the guideline lease. It is also referred to as tax-oriented lease. If a contract is a guideline lease, then the lessor can claim deduction on depreciation and the lessee can claim deduction on the leases paid.

4. What effect does leasing have on a firm’s balance sheet?

Answer: If the contract is a capital lease, it is shown in the firm’s balance sheet. If the contract is an operating lease, then it is shown in the firm’s notes to financial statements.

5. What effect does leasing have on a firm’s capital structure?

Answer: Lease is a substitute to debt financing. This increases the firm’s financial leverage.

6. What is the present value of owning the equipment? (Hint: Set up a time line that shows the net cash flows over the period to, and then find the PV of these net cash flows, or the PV cost of owning.)

Answer: In order to calculate the cost of owning, the depreciation schedule must be created:

Year	MACRS Rate	Depreciation	Year-End 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 is then calculated as:

	0	1	2	3	4
Loan Payment		-60,000	-60,000	-60,000	-1,060,000
Tax Savings on Depreciation		132,000	180,000	60,000	28,000
Maintenance	-12,000	-12,000	-12,000	-12,000
Residual Value					120,000
Net Cash Flow	-12,000	60,000	108,000	-12,000	-912,000

Notes-

• Depreciation is a tax deductible expense, which results in tax savings. Thus tax saving in year 1 for instance is 0.4 * 330,000 = $ 132,000.
• Maintenance expense is $20,000 p.a., but as it is tax deductible, after tax maintenance expense would be (1-t) * 20,000 = $ 12,000.
• As the ending book value is 0, thus the tax is fully payable on the salvage value of the asset.

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

7. Explain the rationale for the discount rate you used to find the PV.

Answer: Discount rate depends on the riskiness of cash flows and the interest rates prevailing in the market. As the maintenance cost and the loan installments are fixed under the contract, they are not risky. Further, the depreciation expense is also constant. But the tax rate may change. This means that the depreciation expense is relatively certain. However, the salvage value is highly uncertain. So, using capital budgeting techniques these cash flows are relatively safe, thus a lower discount rate can be used.

It must be noted that there is some risk involved in relation to debt payments. Therefore, we can say that lease financing has somewhat about the same risk as debt financing. So the appropriate discount rate is the cost of debt. After tax cost of debt will be 6%. Thus, 6% is used as discount rate.

8. What is Lewis’s present value of leasing the equipment? (Hint: Again, construct a time line.)

Answer: If Lewis leases the equipment, then the cash flows each year would be after-tax lease payments. This is tabulated below-

	0	1	2	3	4
Lease Payments	-156,000	-156,000	-156,000	-156,000	-156,000

Lease payments are tax deductible, thus after-tax lease payments = (1 - t) * 260,000 = $ 156,000.

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

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

The net advantage of leasing would be $ 18,751.

NAL= PV of Cast of Owning- PV of Cost of Leasing = $ 591,741 – 572,990 = $ 18,751.

As NAL is positive, the PV of Cost of Owning is greater. Therefore, leasing is less expensive than buying. Thus, Lewis must lease the equipment rather than purchasing it.

10. 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?

Answer: it must be noted that the lease is either shown in the ‘cost of owning’ or the ‘cost of leasing section’. This depends on the company’s plan to continue the using the asset on lease even after the expiry of the contract. So if the company chooses to continue using the asset, this means that when the contract expires, the asset has to be purchased and the salvage value will be shown in the leasing cost section. However, if the lessee plans to discontinue using the equipment then the salvage value will not be shown in leasing section but will be shown in the cost of owning section.

In Lewis’ case, the asset will not be continued to be in use after expiration, thus the salvage value will be shown in owning section. In such a case, the risk increases and thus the discount rate also increases. This leads to higher cost of owning and thus leasing becomes attractive.

It must be noted that if Lewis had decided to lease and then exercise the purchase option, then the company would have continued to use the equipment. In such situation, the salvage value would be shown in leasing section and the risk would be reflected in low discount rate.

Further, the lessor would have the ownership of the asset not the lessee. As a result, the risk associated with salvage value transfers from the lessee to the lessor. In such situation, the lessor would compensate the residual value in the lease payments to avoid loss. However, leasing companies have gained the knowledge and the expertise in order to reduce the salvage value risk. Further, as they lease number of assets they can accurately estimate the salvage value. This eases the whole process.

11. 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: For the lessor, the lease is an investment, thus the lessor must look for returns that can be earned on alternative investments which carry similar risk.