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 infor-mation 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 borrowand-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 leaseversus-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 timeline that shows the net cash flows over the period t 5 0 to t 5 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 timeline.) 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 write the
lease?
Sample Solution
