Lease vs. Purchase Analysis
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.
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Lease vs. Purchase Analysis
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 25%. 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?
2. What are the four 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 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 of owning.)
2. What is the discount rate for the cash flows of owning?
C. What is Lewis’s present value of leasing the equipment? (Hint: Again, construct a time line.)
D. What is the net advantage to leasing (NAL)? Does your analysis indicate that Lewis should 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 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’ lease-versus-purchase decision?
F. The lessee compares the present value of owning the equipment with the present value 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?
Lease vs. Purchase Analysis
a. 1. Who are the two parties to a lease transaction?
In a lease transaction, the two primary parties involved are the lessee and the lessor. The lessee is the entity that leases the asset for use, typically making periodic payments in exchange for the right to use the asset. The lessor is the entity that owns the asset and leases it out to the lessee, receiving lease payments in return for granting the use of the asset over a specified period.
a. 2. What are the four primary types of leases, and what are their characteristics?
The four primary types of leases are operating leases, capital leases (finance leases), leveraged leases, and sale-and-leaseback transactions. An operating lease is short-term and does not transfer ownership risks or rewards to the lessee. It is typically cancellable and often includes maintenance. A capital lease is a long-term lease that transfers most of the risks and rewards of ownership to the lessee, with the lessee assuming responsibility for maintenance, taxes, and insurance. A leveraged lease involves three parties: the lessee, lessor, and lender, where the lessor borrows a significant portion of the funds to acquire the asset. Finally, a sale-and-leaseback occurs when an asset owner sells it to another party and then leases it back, allowing the original owner to retain use of the asset while freeing up capital.
a. 3. How are leases classified for tax purposes?
For tax purposes, leases are classified into capital leases and operating leases. A capital lease is treated similarly to a loan, allowing the lessee to claim depreciation on the asset and deduct interest expenses. The lease payments made by the lessee also consist of both principal and interest components. In contrast, an operating lease does not transfer ownership and is treated as a rental agreement. The lessee cannot depreciate the asset but can deduct the full lease payment as an…