III. Cost Comparison
Net advantage to leasing (NAL)= PV of leasing – PV of owning
= −$777,532.77 – (−$885,679.47)
= $108,146.69.
19-5 a. Borrow and buy analysis:
Depreciation Schedule of New Equipment
Year
0
1
2
3
4
5
6
Depreciation rates for
Amortization Schedule of Loan
Year
0
1
2
3
4
5
6
Answers and Solutions: 19 – 14
Cost of Owning
Year
0
1
2
3
4
5
6
Loan payments
–257,157.5
–257,157.5
–257,157.5
–257,157.5
–257,157.5
–257,157.5
Depreciation Schedule of Used Equipment
Year
0
1
2
3
4
5
6
Book Value
0
Depreciation Schedule
Cost of Leasing
Year
0
1
2
3
4
5
6
After–tax lease payment
–184,800.0
–184,800.0
–184,800.0
Market value of machine
–200,000.0
Depreciation tax savings
Net cash flow
–184,800.0
–184,800.0
–407,464.4
PV @ after–tax cost of
Net advantage to leasing
Net advantage to leasing = −667,261 – (−713,300) = 46,039.
Answers and Solutions: 19 – 15
Purchase of
Loan proceeds
Notes:
aDiscount rate = 14% x (1 – T) = 14% x (1 – 0.34) = 9.24%.
bDepreciable basis = Cost = $1,000,000. MACRS allowances = 33.33%, 44.45%,
14.81%. Depreciation tax savings = T(Depreciation).
cCost of purchasing the machinery after the lease expires. Note that since the firm is
b. Using Goal Seek, we find that the purchase price can go up to $245,703 before the
NAL becomes negative.
c. We assume that the company will buy the equipment at the end of 3 years if the lease
plan is used; hence, the $200,000 is an added cost under leasing. We discounted it, and
the resulting depreciation tax shields, at 9.24 percent, but these cash flows are risky, so
should we use a higher rate? Since the purchase cost net of the present value of the
Answers and Solutions: 19 – 16
SOLUTION TO SPREADSHEET PROBLEM
19-6 The detailed solution for the spreadsheet problem, Ch19 P06 Build a Model Solution.xls,
is available on the textbook’s web site.
Answers and Solutions: 19 – 17
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?
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
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?
Answer: If the lease is classified as a capital lease, it is shown directly on the balance sheet. If
a. 5. What effect does leasing have on a firm’s capital structure?
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.)
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
Cost Of Owning Time Line:
0 1 2 3 4
| | | | |
AT Loan Payment -60,000 -60,000 -60,000 -1,060,000
Mini Case: 19 – 20
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
c. What is Lewis’s present value cost 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:
Mini Case: 19 – 21
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:
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.
Mini Case: 19 – 22
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
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?
Answer: The lessor should view “writing” the lease as an investment, so the lessor should
compare the return on the lease with returns available on alternative investments of
similar risk.
Mini Case: 19 – 23
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:
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 lessor’s
Mini Case: 19 – 24
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
Mini Case: 19 – 25