The purpose of this assignment is to explain core concepts related to lease vs. purchase and tactical financial decisions.
Read the Chapter 19 Mini Case on pages 796-797 in Financial Management: Theory and Practice. Using complete sentences and academic vocabulary, please answer questions a through f. APA format is not required, but solid academic writing is expected.
Reference: Brigham, E.F., &Ehrhardt, M.C. (2014). Financial Management: Theory and Practice (14th ed.). Mason, OH: South-WesternCengage Learning.
Lewis Securities Inc. has decided to acquire a new market data and quotation system forits Richmond home office. The system receives current market prices and other informationfrom several online data services and then either displays the information on a screenor stores it for later retrieval by the firm' s brokers. The system also permits customers tocall up current quotes on terminals in the lobby.
The equipment costs $1,000,000 and, if it were purchased, Lewis could obtain a termloan 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 theMACRS 3-year class. If the system were purchased, a 4-year maintenance contract couldbe obtained at a cost of $20,000 per year, payable at the beginning of each year. Theequipment 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, theactual 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 guidelinelease on the equipment, including maintenance, for payments of $260,000 at thebeginning of each year. Lewis' s marginal federal-plus-state tax rate is 40%. You havebeen 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?
(2) What are the five primary types of leases, and what are their characteristics?
(3) How are leases classified for tax purposes?
(4) What effect does leasing have on a firm' s balance sheet?
(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 linethat shows the net cash flows over the period t = 0 to t = 4, and then find the PVof these net cash flows, or the PV cost of owning.)
(2) Explain the rationale for the discount rate you used to find the PV.
c. What is Lewis' s present value cost of leasing the equipment? (Hint: Again, construct atime line.)
d. What is the net advantage to leasing (NAL)? Does your analysis indicate that Lewisshould buy or lease the equipment? Explain.
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 thanthe other relevant cash flows, this differential risk should beincorporated into theanalysis. Describe how this could be accomplished. (No calculations are necessary, butexplain how you would modify the analysis if calculations were required.) What effectwould the residual value' s increased uncertainty have on Lewis' s lease-versuspurchasedecision?
f. The lessee compares the cost of owning the equipment with the cost of leasing it. Nowput yourself in the lessor' s shoes. In a few sentences, how should you analyze thedecision to write or not to write the lease?