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Automobiles are often leased, and several terms are unique to auto leases. Suppose you are considering leasing a car. The price you and the dealer agree on for the car is $38,600. This is the base capitalized cost. Other costs added to the capitalized cost price include the acquisition (bank) fee, insurance, or extended warranty. Assume these costs are $1,150. Capitalization cost reductions include any down payment, credit for trade-in, or dealer rebate. Assume you make a down payment of $2,500, and there is no trade-in or rebate. If you drive 12,000 miles per year, the lease-end residual value for this car will be $26,400 after three years. The lease or "money" factor, which is the interest rate on the loan, is the APR of the loan divided by 2,400. The lease factor the dealer quotes you is .00261. The monthly lease payment consists of three parts: a depreciation fee, a finance fee, and sales tax. The depreciation fee is the net capitalization cost minus the residual value, divided by the term of the lease. The net capitalization cost is the cost of the car minus any cost reductions plus any additional costs. The finance fee is the net capitalization cost plus the residual, times the money factor, and the monthly sales tax is the depreciation payment plus the finance fee, times the tax rate.

What APR is the dealer quoting you? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

APR %

What is your monthly lease payment for a 36-month lease if the sales tax is 7 percent? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Lease payment $

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Casey Durgan
Casey DurganLv2
28 Sep 2019

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Automobiles are often leased, and several terms are unique to auto leases. Suppose you are considering leasing a car. The price you and the dealer agree on for the car is $30,500. This is the base capitalized cost. Other costs added to the capitalized cost price include the acquisition (bank) fee, insurance, or extended warranty. Assume these costs are $750. Capitalization cost reductions include any down payment, credit for trade-in, or dealer rebate. Assume you make a down payment of $2,000, and there is no trade-in or rebate. If you drive 12,000 miles per year, the lease-end residual value for this car will be $21,400 after three years. The lease or "money" factor, which is the interest rate on the loan, is the APR of the loan divided by 2,400. The lease factor the dealer quotes you is .00283. The monthly lease payment consists of three parts: a depreciation fee, a finance fee, and sales tax. The depreciation fee is the net capitalization cost minus the residual value, divided by the term of the lease. The net capitalization cost is the cost of the car minus any cost reductions plus any additional costs. The finance fee is the net capitalization cost plus the residual, times the money factor, and the monthly sales tax is the depreciation payment plus the finance fee, times the tax rate.What is your monthly lease payment for a 36-month lease if the sales tax is 7 percent? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

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 firm’s brokers. Thesystem also permits customers to call up current quotes onterminals in the lobby.

The equipment costs $1,000,000 and, if it were purchased, Lewiscould obtain a term loan for the full purchase price at a 10%interest rate. Although the equipment has a 6-year useful life, itis classified as a special-purpose computer and therefore fallsinto the MACRS 3-year class. If the system were purchased, a 4-yearmaintenance contract could be obtained at a cost of $20,000 peryear, payable at the beginning of each year. The equipment would besold after 4 years, and the best estimate of its residual value is$200,000. However, because real-time display system technology ischanging rapidly, the actual residual value is uncertain.

As an alternative to the borrow-and-buy plan, the equipmentmanufacturer informed Lewis that Consolidated Leasing would bewilling to write a 4-year guideline lease on the equipment,including maintenance, for payments of $260,000 at the beginning ofeach year. Lewis’s marginal federal-plus-state tax rate is 40%. Youhave been asked to analyze the lease-versus-purchase decision and,in the process, to answer the following questions:

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

    2. What are the 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 firm’s balance sheet?

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

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

    2. Explain the rationale for the discount rate you used to find thePV.

  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 analysisindicate that Lewis should buy or lease the equipment? Explain.

  5. Now assume that the equipment’s residual value could be as lowas $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 incorporated 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 value’sincreased uncertainty have on Lewis’ lease-versus-purchasedecision?

  6. The lessee compares the present value of owning the equipmentwith the present value of leasing it. Now put yourself in thelessor’s shoes. In a few sentences, how should you analyze thedecision to write or not to write the lease?

FINANCIAL MANAGEMENT

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.

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 = 0 to t = 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.

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

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 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-versus-purchase decision?

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?

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