978-1305637108 Chapter 19 Solution Manual Part 2

Answers and Solutions: 19 – 11

Year

0

1

2

3

4

5

6

After-tax lease payment

-211,200

Purchase of machine at end of

lease (last day of 3rd year,

t=2.99)

-200,000.0

Depreciation tax savings

22,664.4

30,226.0

10,070.8

5,038.8

Net cash flow of leasing

0.00

-211,200

–388,535.6

30,226.0

10,070.8

5,038.8

PV of leasing @ after-tax cost

of debt (9.24%)

–

637,702

Net advantage to leasing = PV of leasing – PV of owning

= −637,702 − (−713,300) = 75,598.

Because the NAL is positive, the company should choose the lease.

Note that the maintenance expense is excluded from the analysis since the firm

will have to bear the cost whether it buys or leases the machinery.

Because the firm is keeping the machine for at least 6 years (either because it

Answers and Solutions: 19 – 12

website, in whole or in part.

SOLUTION TO SPREADSHEET PROBLEM

19-6 The detailed solution for the spreadsheet problem, Ch19 P06 Build a Model

Solution.xlsx, is available on the textbook’s web site.

Mini Case: 19 – 13

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?

Mini Case: 19 – 14

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

equipment, and contains a cancellation clause. A financial lease does not provide for

maintenance service, is not cancelable, and is fully amortized; that is, the lease covers

the entire expected life of the equipment. In a sale and leaseback arrangement, the

firm owning the property sells it to another firm, often a financial institution, while

simultaneously entering into an agreement to lease the property back from the firm. A

sale and leaseback can be thought of as a type of financial lease. A combination lease

company guarantees the SPE’s debt, and enters into an operating lease with it. This

arrangement has been used to avoid capitalizing the lease and therefore reporting it as

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

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?

Mini Case: 19 – 15

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

depreciable basis = $1,000,000.

MACRS Depreciation End-Of-Year

Present Value Of Owning Time Line:

0 1 2 3 4

| | | | |

t(depreciation). For example, the savings in year 1 is 0.4($333,300) = $133,320.

Mini Case: 19 – 16

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)

relatively safe, so they should be discounted at a relatively low rate. In fact, they

have about the same degree of riskiness as the firm’s debt cash flows (which also

have some tax rate risk, and which are also contractual in nature). Therefore, we

conclude that leasing has about the same impact on the firm’s financial risk as debt

financing, so the appropriate discount rate is Lewis’s cost of debt. (Note: the larger

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

how to adjust for the salvage (residual) value risk. Therefore, what we have been

doing is running the analysis on a spreadsheet model and making a data table where

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

| | | | |

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

purchased when the lease expires, and in this case the residual value appears as a cost

value of the residual cash flow. This leads to a higher cost of owning, so the greater

the risk of the residual value, the higher the cost of owning, and the more attractive

leasing becomes.

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

Mini Case: 19 – 18

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

course, the lessor recognizes this, and as a result, assets with highly uncertain residual

values will carry higher lease payments than assets with relatively certain residual

values. However, the most successful leasing companies have developed expertise in

renovating and disposing of used equipment, and this gives them an advantage over

most lessees in reducing residual value risks.

Further, leasing companies usually deal with a wide array of assets, so residual value

estimates that are too high on one asset may be offset by estimates that are too low on

another.

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?

Mini Case: 19 – 19

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

Maintenance (AT) -12,000 -12,000 -12,000 -12,000

Lease Pmt.(AT) 168,000 168,000 168,000 168,000

Res. Value (AT) __________ _______ _______ _______ 120,000

Net Cash Flow -844,000 289,320 333,800 215,240 149,640

NPV @ 6% = $25,273.

IRR = 7.46%.

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

by $20,000(0.6) = $12,000 at the beginning of each year. The PV of this annuity is

website, in whole or in part.

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

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

lease. If its situation changed, so that Lewis either no longer needed the equipment or

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

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

cancellation. The decision as to whether or not to include a cancellation clause would

depend on who was in a better position to bear the residual value risk, the lessee or

the lessor. Often lessors have more expertise at disposing of used equipment than

lessees, and thus they are willing to include cancellation clauses without major

increases in the required lease payments.