Question

approp cash flows, at what lease payment wold buying? C. Assuming that the alle NI CASE Lewis Securities Inc. has decided to acquire a new market data and quotation s its Richmond home office. The system receives current market prices and other inf tion from several online data services and then either displays the information on or stores it for later retrieval by the firm's brokers. T call up current quotes on terminals in the lobby system for orma he system also permits customers to 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% interest rate. Although the equipment has a 6-year useful life, it is classified as a special-purpose computer and therefore 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 is $20,000 However, because real-time display system technology is changing rapidy tho actual residual value is uncertain. As an alternative to the borrow-and-buy plan, the equipment man informed Lewis that Consolidated Leasing would be willing to write a 4-yearb lease on the equipment, including maintenance, for payments of $2 ginning of each year. Lewis's marginal federal-plus-state tax rate is s been asked to analyze the lease-versus-purchase decision and, in the following questions 40%. You have e process, to answer

Answer 1

E. 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 in the leasing cost section. However, if the lessee plans not to continue using the equipment, then the residual value will not be shown in the leasing section-rather, it will be shown as an inflow in the cost of owning section. In Lewis's case, the asset will not be needed at the expiration of the lease, so the residual is shown as an inflow in the owning section. In this situation, we account for increased risk by increasing the rate used to discount the residual value cash flow, resulting in a lower present 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 equipment. Then the residual would be shown as a cost in the leasing section, and its higher risk would be reflected by discounting it at a lower rate. In that situation the riskiness of the residual would penalize rather than help the lease 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

The lessor should view "writing" the lease as an investment, so the lessor should compare the returm on the lease with returns available on alternative investments of similar risk G1. 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: 4 Cost f Asset Dep. Tax Savings Maintenance (AT) Lease Pmt (AT) Res. Value (AT) Net Cash Flow 1,000,000 132,000 180,000 0,000 28,000 12,000-12,000 12,000 12,000 168,000 168,000 168,000168,000 NPV @ 6%-$25,325 IRR 7.46% . G2. 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 NPV would be-$18,751, the negative of the lessee's NAL. To verify this, note that a $20,000 reduction in each lease payment would reduce the lessor's inflows by $20,000 (0.6) $12,000 at the beginning of each year. The PV of this annuity is $44,076, so the lessor's NPV would be $25,325 $44,076-$18,752, which is identical except for rounding differences.

H. 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 else wanted to change to a more technologically advanced product, then it could terminate the lease. However, a cancellation clause would make the contract more risky for the lessor Now the lessor bears not only the final residual value risk, but also the uncertainty of when the contract will be terminated. 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 ancellation. 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.