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 online data services and 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% 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 $200,000. However, because 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%. (E) Now assume that the equipment' s residual value could be as low as $0 or as high as $400,000, but $200,000 is the expected value.
Because the residual value is riskier than the other relevant cash flows, 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 the residual value' s increased uncertainty have on Lewis' s lease-versuspurchase decision?