978-1305632295 Chapter 19 Solution Manual Part 2

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MINI CASE

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 on-line data services, 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 percent interest rate. Although the equipment has a

six-year useful life, it is classified as a special-purpose computer, so it 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 at that time is

$200,000. However, since 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 percent. 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?

Answer: The two parties are the lessee, who uses the asset, and the lessor, who owns the asset.

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website, in whole or in part.

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

Answer: The five primary types of leases are operating, financial, sale and leaseback,

combination, and synthetic. An operating lease, sometimes called a service lease,

provides for both financing and maintenance. Generally, the operating lease contract

is written for a period considerably shorter than the expected life of the leased

a. 3. How are leases classified for tax purposes?

Answer: A guideline lease is a lease that meets all of the IRS requirements for a genuine lease.

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

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

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website, in whole or in part.

b. 1. What is the present value of owning the equipment? (Hint: set up a time line

which 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.)

Answer: To develop the cost of owning, we begin by constructing the depreciation schedule:

depreciable basis = $1,000,000.

MACRS Depreciation End-Of-Year

Year Rate Expense Book Value

1 0.3333 $ 333,300 $666,700

Present Value Of Owning Time Line:

0 1 2 3 4

| | | | |

AT Loan Payment -60,000 -60,000 -60,000 -1,060,000

1Depreciation is a tax-deductible expense, so it produces a tax savings of

3The ending book value is $0, so taxes must be paid on the full $200,000 salvage

(residual) value.

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website, in whole or in part.

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

Answer: The proper discount rate depends on (1) the riskiness of the cash flow stream and (2)

the general level of interest rates. The loan payments and the maintenance costs are

fixed by contract, hence are not at all risky. The depreciation deductions are also

Note: when we have been engaged as consultants on lease-versus-buy decisions,

the proper discount rate is often discussed. We know of no way to specify exactly

c. What is Lewis’s present value of leasing the equipment? (Hint: again, construct

a time line.)

Answer: If Lewis leased the equipment, its only cash flows would be the after-tax lease

payments:

0 1 2 3 4

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website, in whole or in part.

d. What is the net advantage to leasing (NAL)? Does your analysis indicate that

Lewis should buy or lease the equipment? Explain.

Answer: The net advantage to leasing (NAL) is $18,751:

NAL= PV of leasing − PV of owning

e. Now assume that the equipment’s residual value could be as low as $0 or as high

as $400,000, but that $200,000 is the expected value. Since the residual value is

riskier than the other cash flows in the analysis, 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 increased uncertainty about the

residual value have on Lewis’s lease-versus-purchase decision?

Answer: First, note that the residual value in a lease analysis will be shown either in the “cost

of owning section” or in the “cost of leasing” section, depending on whether or not

the company plans to continue using the leased asset at the expiration of the basic

lease. If the lessee plans to continue using the equipment, then it will have to be

Note, though, that the situation would be different if Lewis planned to lease and

then exercise a fair market value purchase option in order to continue using the

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website, in whole or in part.

In the case at hand, the lessor, not the lessee, will own the asset at the end of the

lease, so the lessor bears the residual value risk. In effect, the lease transaction passes

the risk associated with the residual value from the lessee/user to the lessor. Of

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 write the lease?

Answer: The lessor should view “writing” the lease as an investment, so the lessor should

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website, in whole or in part.

g. 1. Assume that the lease payments were actually $280,000 per year, that

Consolidated Leasing is also in the 40 percent tax bracket, and that it also

forecasts a $200,000 residual value. Also, to furnish the maintenance support,

Consolidated 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 percent pre-tax return on

investments of similar risk. What would Consolidated’s NPV and IRR of leasing

be under these conditions?

Answer: The lessor must invest $1,000,000 to buy the equipment, but then it expects to receive

tax benefits and lease payments over the life of the lease. Note that the depreciation

expenses calculated earlier also apply to the lessor, so we have this cash flow stream:

01234

| | | | |

Cost Of Asset -1,000,000

Dep. Tax Savings 133,320 177,800 59,240 29,640

g. 2. What do you think the lessor’s NPV would be if the lease payment were set at

$280,000 per year? (Hint: the lessor’s cash flows would be a “mirror image” of

the lessee’s cash flows.)

Answer: With lease payments of $260,000, the lessor’s cash flows would be the “mirror

image” of the lessee’s NAL–the same dollars, but with signs reversed. Therefore, the

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h. Lewis’s management has been considering moving to a new downtown location,

and they are concerned that these plans may come to fruition prior to the

expiration of the lease. If the move occurs, Lewis would buy or lease an entirely

new set of equipment, and hence management would like to include a

cancellation clause in the lease contract. What impact would such a clause have

on the riskiness of the lease from Lewis’s standpoint? From the lessor’s

standpoint? If you were the lessor, would you insist on changing any of the lease

terms if a cancellation clause were added? Should the cancellation clause

contain any restrictive covenants and/or penalties of the type contained in bond

indentures or provisions similar to call premiums?

Answer: A cancellation clause would lower the risk of the lease to Lewis, the lessee, because

then it would not be obligated to make the lease payments for the entire term of the

However, a cancellation clause would make the contract more risky for the lessor.

To account for the additional risk, the lessor would undoubtedly increase the

annual lease payment. Additionally, the lessor might include clauses that would

prohibit cancellation for some period and/or impose a penalty fee for early

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website, in whole or in part.