New Equipment life 4
Equip. Residual Value $200 LEASE
Tax Rate 40%
because the net advantage of leasing is
Loan interest rate 10%
Annual rental charge $260
After-tax cost of debt 6%
Maintenance if not leased $20
Equipment cost ($1,000)
Loan amount $1,000
Interest expense ($100) ($100) ($100) ($100)
Tax savings from interest 40 40 40 40
Principal repayment ($1,000)
After tax loan payment ($60) ($60) ($60) ($1,060)
Depreciation shield $133.320 $177.800 $59.240 $29.640
Tax savings on maintenance
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A B C D E F G H I J
12/10/2012
Input Data
(all dollar figures in thousands)
New Equipment cost $1,000 KEY OUTPUT
NPV LEASE ANALYSIS
Depreciation Rate 33.33% 44.45% 14.81% 7.41%
Depreciation Expense 333.30 444.50 148.10 74.10
BV at end of year 666.70 222.20 74.10 –
Year = 0 1 2 3 4
Chapter 19. Mini Case for Lease Financing
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.
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:
b. (1) What is the present value cost 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.)
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risk. If the residual value were included as an outflow (a negative CF) in the cost of leasing cash flows, the increased
Principal repayment ($1,000)
After tax loan payment ($60) ($60) ($60) ($1,060)
Depreciation shield $133.320 $180.000 $60.000 $28.000
Tax savings on maintenance
Tax on residual value ($80)
Cash flow without residual $ (12) $ 61 $ 108 $ (12) $ (1,112)
Residual cash flow $ – $ – $ – $200
PV minus residual @ 6% (748.91)$
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A B C D E F G H I J
Residual value $200
Tax on residual value ($80)
Net cash flow ($12.000) $61.320 $105.800 ($12.760) ($910.360)
PV ownership cost @ 6% ($591.793)
c. What is Lewis’s present value cost of leasing the equipment? (Hint: Again, construct a time line.)
Year = 0 1 2 3 4
Cost of Leasing
Cost Comparison
Alter the Residual Discount Rate to see the effect on PV
Year = 0 1 2 3 4
Cost of Owning
Equipment cost ($1,000)
Loan amount $1,000
Interest expense ($100) ($100) ($100) ($100)
Tax savings from interest $40 $40 $40 $40
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?
(2) Explain the rationale for the discount rate you used to find the
Leasing is similar to debt financing in that the cash flows have relatively low risk because most are fixed by contract.
d. What is the net advantage to leasing (NAL)? Does your analysis indicate that Lewis should buy or lease the
equipment? Explain.
If all inputs are symmetrical, leasing is a zero-sum game.
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A B C D E F G H I J
NPV LEASOR’S ANALYSIS
Lease payment = $280
Lessor’s tax rate = 40%
Lessor’s pre-tax interest rate = 10%
After-tax discount rate = 6.00%
Year = 0 1 2 3 4
Cost of Owning
With lease payments of $260,000, the lessor’s cash flows would be equal, but opposite in sign, to the lessee’s NAL.
A cancellation clause would lower the risk of the lease to the lessee but raise the lessor’s risk. To account for this, the
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?
f. The lessee compares the cost of owning the equipment with the cost of leasing it. Now put yourself in the lessor’s
g. (1) Assume that the lease payments were actually $280,000 per year, that Consolidated Leasing is also in the 40
(2) What do you think the lessor’s NPV would be if the lease payments were set at $260,000 per year? (Hint: The
lessor’s cash flows would be a “mirror image” of the lessee’s cash flows.)
The lessor owns the equipment when the lease expires. Therefore, residual value risk is passed from the lessee to the
lessor. The increased residual value risk makes the lease more attractive to the lessee.
To the lessor, writing the lease is an investment. Therefore, the lessor must compare the return on the lease
investment with the return available on alternative investments of similar risk.
shoes. In a few sentences, how should you analyze the decision to write or not write the lease?