core concepts related to lease vs. purchase and tactical financial decisions.

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.

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 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%. You have been asked to analyze the lease-versus-purchase decision and, in the process, to

answer the following questions.

 

(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?

 

(1) What is the present value cost of owning the equipment? (Hint: Set up a time line

that 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.)

(2) Explain the rationale for the discount rate you used to find the PV.

 

  1. What is Lewis’s present value cost of leasing the equipment? (Hint: Again, construct atime line.)
  2. What is the net advantage to leasing (NAL)? Does your analysis indicate that Lewis

should buy or lease the equipment? Explain.

  1. 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?

  1. 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 to write the lease?

 

Rubric

Mini Case 8

  1
Unsatisfactory
0.00%
2
Less than Satisfactory
74.00%
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Satisfactory
79.00%
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Good
87.00%
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Excellent
100.00%
100.0 %Content  
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100 %Total Weightage  

 

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