1
2
3
4
5
6
7
8
9
10
11
17
18
19
20
21
22
23
24
25
26
27
28
(4) What effect does leasing have on a firm’s balance sheet? Answer: See Chapter 19 Mini Case Show
(3) How are leases classified for tax purposes? Answer: See Chapter 19 Mini Case Show
(5) What effect does leasing have on a firm’s capital structure? Answer: See Chapter 19 Mini Case Show
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
Equip. Residual Value $200 LEASE
Tax Rate 25% because the net advantage of leasing is $22.24
Loan interest rate 10%
Annual lease payment $260
After-tax cost of debt 7.5%
Maintenance if not leased $20
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
62
63
64
Equipment cost ($1,000)
Loan amount $1,000
Interest expense ($100) ($100) ($100) ($100)
Tax savings from interest 25 25 25 25
Principal repayment ($1,000)
After tax loan payment ($75) ($75) ($75) ($1,075)
Depreciation shield $83 $111 $37 $19
Tax savings on maintenance
Residual value $200
Tax on residual value ($50)
A B C D E F G H I
11/23/2018
Input Data
(all dollar figures in thousands)
New Equipment cost $1,000 KEY OUTPUT
New Equipment life 4
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
Present Value of Owning
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.)
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.
(2) What are the four primary types of leases, and what are their characteristics? Answer: See Chapter 19 Mini Case
Show
The equipment costs $1,000,000, and, if it were purchased, Lewis could obtain a term loan for the full purchase price at a
As an alternative to the borrow-and-buy plan, the equipment manufacturer informed Lewis that Consolidated Leasing
a. (1) Who are the two parties to a lease transaction? Answer: See Chapter 19 Mini Case Show
12
13
14
15
16
65
66
67
68
69
70
74
75
76
77
78
79
80
81
Tax savings from lease $65 $65 $65 $65
Net cash flow ($195) ($195) ($195) ($195)
82
83
84
85
86
87
88
89
90
91
PV of leasing @ 7.5% ($702.103)
PV ownership cost @ 7.5% ($724.341)
Net Advantage to Leasing $22.238
92
93
94
95
96
97
98
99
100
101
102
103
104
If the residual value were included as an outflow (a negative CF) in the cost of leasing cash flows, the increased risk would
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
Tax savings from interest $25 $25 $25 $25
Principal repayment ($1,000)
After tax loan payment ($75) ($75) ($75) ($1,075)
Depreciation shield $83.325 $180.000 $60.000 $28.000
Tax savings on maintenance
Tax on residual value ($50)
Cash flow without residual $ (15) $ (7) $ 90 $ (30) $ (1,097)
Residual cash flow $ – $ – $ – $200
PV minus residual @ 6% (788.91)$
PV of residual @
125
126
127
A B C D E F G H I
Net cash flow ($15.000) ($6.675) $21.125 ($52.975) ($906.475)
PV ownership cost @ 7.5 ($724.341)
c. What is Lewis’s present value cost of leasing the equipment? (Hint: Again, construct a time line.)
Year = 0 1 2 3 4
Lease payment ($260) ($260) ($260) ($260)
Net Advantage of Leasing
Alter the Residual Discount Rate to see the effect on PV
Year = 0 1 2 3 4
Present Value of Owning
Equipment cost ($1,000)
Loan amount $1,000
Interest expense ($100) ($100) ($100) ($100)
d. What is the net advantage to leasing (NAL)? Does your analysis indicate that Lewis should buy or lease the equipment?
Explain.
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.
The discount rate applied to the residual value inflow (a positive CF) should be increased to account for the increased risk.
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) What is the discount rate for the cash flows of owning?
Leasing is similar to debt financing in that the cash flows have relatively low risk because most are fixed by contract.
71
72
73
128
129
130
134
135
136
137
138
139
140
141
142
143
144
145
146
147
148
149
150
151
152
153
154
155
156
157
158
159
Depreciation shield 83 111 37 19
Tax savings on maintenance
Lease payment 280.00 280.00 280.00 280.00
Tax on lease payment -70.00 -70.00 -70.00 -70.00
Residual value 200.00
Tax on residual value -50.00
Net cash flow -805 278 306 232 169
161
162
163
164
165
166
167
168
169
170
171
172
173
174
175
176
177
178
179
180
181
182
183
184
185
186
187
188
189
190
A B C D E F G H I
NPV LEASOR’S ANALYSIS
Lease payment = $280
Lessor’s tax rate = 25%
Lessor’s pre-tax interest rate =
10%
After-tax discount rate = 7.50%
Year = 0 1 2 3 4
Equipment cost -1000.00
With lease payments of $260,000, the lessor’s cash flows would be equal, but opposite in sign, to the lessee’s NAL.
(22,238)
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
shoes. In a few sentences, how should you analyze the decision to write or not write the lease?
g. (1) Assume that the lease payments were actually $280,000 per year, that Consolidated Leasing is also in the 25 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?
(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.)
If all inputs are symmetrical, leasing is a zero-sum game.
To verify this, note that a $20,000 reduction in each lease payment would reduce the lessor’s inflows by $20,000(0.75) =
$15,000 at the beginning of each year.
131
132
191
192
193
197
198
A B C D E F G H I
i. What are some other issues in lease analysis? Answer: See Chapter 19 Mini Case Show
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?
194
195