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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.
Mini Case: 19 - 1
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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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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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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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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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