The purpose of this assignment is to explain core concepts related to lease vs. purchase and tactical financial decisions

FIN 650

Lewis Securities Inc. has decided to acquire a new market data and quotation system for

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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 25%. 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 four 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 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 of owning.)

(2) What is the discount rate for the cash flows of owning?

c. What is Lewis’s present value 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 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?

f. 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?

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