Lewis Securities Inc. has decided to acquire a new market dataand quotation system for its Richmond home office. The systemreceives current market prices and other information from severalonline data services and then either displays the information on ascreen or stores it for later retrieval by the firmâs brokers. Thesystem also permits customers to call up current quotes onterminals in the lobby. The equipment costs $1,000,000 and, if itwere purchased, Lewis could obtain a term loan for the fullpurchase price at a 10% interest rate. Although the equipment has a6-year useful life, it is classified as a special-purpose computerand therefore falls into the MACRS 3-year class. If the system werepurchased, a 4-year maintenance contract could be obtained at acost of $20,000 per year, payable at the beginning of each year.The equipment would be sold after 4 years, and the best estimate ofits residual value is $200,000. However, because real-time displaysystem technol- ogy is changing rapidly, the actual residual valueis uncertain. As an alternative to the borrow-and-buy plan, theequipment manufacturer informed Lewis that Con- solidated Leasingwould be willing to write a 4-year guideline lease on theequipment, including mainte- nance, for payments of $260,000 at thebeginning of each year. Lewisâ marginal federal-plus-state tax rateis 40%. You have been asked to analyze the lease- versus-purchasedecision and, in the process, to answer the following questions: a.(1) Who are the two parties to a lease transaction? (2) What arethe five primary types of leases, and what are theircharacteristics? (3) How are leases classified for tax purposes?(4) What effect does leasing have on a firmâs balance sheet? (5)What effect does leasing have on a firmâs capital structure? b. (1)What is the present value cost of owning the equipment? (Hint: Setup a time line that shows the net cash flows over the period t 5 0to t 5 4, and then find the PV of these net cash flows, or the PVcost of owning.) (2) Explain the rationale for the discount rateyou used to find the PV. c. What is Lewisâ present value cost ofleasing the equipment? (Hint: Again, construct a time line.) d.What is the net advantage to leasing (NAL)? Does your analysisindicate that Lewis should buy or lease the equipment? Explain. e.Now assume that the equipmentâs 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 cashflows, this differential risk should be incor- porated into theanalysis. Describe how this could be accomplished. (No calculationsare necessary, but explain how you would modify the analysis ifcalculations were required.) What effect would the residual valueâsincreased uncertainty have on Lewisâ lease-versus-purchasedecision? f. The lessee compares the cost of owning the equipmentwith the cost of leasing it. Now put yourself in the lessorâsshoes. In a few sentences, how should you analyze the decision towrite or not to write the lease? g. (1) Assume that the leasepayments were actually $280,000 per year, that Consolidated Leasingis 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 fromthe manufacturer at the same $20,000 annual cost, again paid inadvance. Consolidated Leasing can obtain an expected 10% pre-taxreturn on investments of similar risk. What would be ConsolidatedâsNPV and IRR of leasing under these conditions? (2) What do youthink the lessorâs NPV would be if the lease payment were set at$260,000 per year? (Hint: The lessorâs cash flows would be aâmirror imageâ of the lesseeâs cash flows.) h. Lewisâ managementhas been considering moving to a new downtown location, and theyare con- cerned that these plans may come to fruition prior to theequipment leaseâs expiration. If the move occurs, then Lewis wouldbuy or lease an entirely new set of equipment, so management wouldlike to include a cancellation clause in the lease contract. Whateffect would such a clause have on the riskiness of the lease fromLewisâ standpoint? From the lessorâs standpoint? If you were theles- sor, would you insist on changing any of the other lease termsif a cancellation clause were added? Should the cancellation clausecontain provi- sions similar to call premiums or any restrictivecovenants and/or penalties of the type contained in bondindentures? Explain your answer.
