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1 Ch 18 Mini Case 3/9/2001

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3 Mini Case for Lease Financing
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5 Lewis Securities Inc. has decided to acquire a new market data and quotation system for its Richmond home office. The
6 system receives current market prices and other information from several on-line data services, then either displays the
7 information on a screen or stores it for later retrieval by the firm's brokers. The system also permits customers to call up
8 current quotes on terminals in the lobby.
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10 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
11 percent interest rate. The equipment is classified as a special-purpose computer, so it 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
12 of each year. The equipment would be sold after 4 years, and the best estimate of its residual value at that time is $100,000.
13 However, since real-time display system technology is changing rapidly, the actual residual value is uncertain.
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18 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 $280,000 at the beginning
19 of each year. Lewis's marginal federal-plus-state tax rate is 40 percent. You have been asked to analyze the lease-versus-
20 purchase decision, and in the process to answer the following questions:
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22 a. (1) Who are the two parties to a lease transaction?
23 (2) What are the four primary types of leases, and what are their characteristics?
24 (3) How are leases classified for tax purposes?
25 (4) What effect does leasing have on a firm's balance sheet?
26 (5) What effect does leasing have on a firm's capital structure?
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28 b. (1) What is the present value cost of owning the equipment? (Hint: Set up a time line which shows the net cash flows over
29 the period t = 0 to t = 4, and then find the PV of these net cash flows, or the PV cost of owning.)
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31 Given Data
32 (all dollar figures in thousands)
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34 New Equipment cost $1,000 KEY OUTPUT
35 New Equipment life 4
36 Equip. Residual Value $100 LEASE
37 Tax Rate 40% because the net advantage of this alternative is $22.20
38 Loan interest rate 10%
39 Annual rental charge $280
40 After-tax cost of debt 6%
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43 NPV LEASE ANALYSIS
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45 Year = 0 1 2 3 4
46 Cost of Owning
47 Equipment cost ($1,000)
48 Loan amount $1,000
49 Interest expense ($100) ($100) ($100) ($100)
50 Tax savings from interest 40 40 40 40
51 Principal repayment ($1,000)
52 After tax loan payment ($60) ($60) ($60) ($1,060)
53 Depreciation shield $132 $180 $60 $28
54 Maintenance ($20) ($20) ($20) ($20)
55 Tax savings on maintenance $8 $8 $8 $8 $0
56 Residual value $100
57 Tax on residual value ($40)
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58 Net cash flow ($12) $60 $108 ($12) ($972)
59 PV ownership cost @ 6% ($639.27) all the value have been discounted
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62 (2) Explain the rationale for the discount rate you used to find the PV.
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64 Leasing is similar to debt financing in that the cash flows have relatively low risk because most are fixed by contract.
65 Therefore the firms 10% cost of debt is a good start. The tax shield of interest payments must be considered.
66 10%(1 - T) = 10%(1 - 0.4) = 6.0%.
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68 c. What is Lewis's present value cost of leasing the equipment? (Hint: Again, construct a time line.)
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70 Year = 0 1 2 3 4
71 Cost of Leasing
72 Lease payment ($280) ($280) ($280) ($280)
73 Tax savings from lease $112 $112 $112 $112
74 Net cash flow ($168) ($168) ($168) ($168) $0
75 PV of leasing @ 6% ($617.07)
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78 d. What is the net advantage to leasing (NAL)? Does your analysis indicate that Lewis should buy or lease the equipment?
79 Explain.
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81 Cost Comparison
82 PV ownership cost @ 6% ($639.27)
83 PV of leasing @ 6% ($617.07)
84 Net Advantage to Leasing $22.20
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87 e. Now assume that the equipment's residual value could be as low as $0 or as high as $200,000, but that $100,000 is the
88 expected value. Since the residual value is riskier than the other cash flows in the analysis, this differential risk should be
89 incorporated into the analysis. Describe how this could be accomplished. (No calculations are necessary, but explain how you
90 would modify the analysis if calculations were required.) What effect would increased uncertainty about the residual value
have on Lewis's lease-versus-purchase decision?
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93 The discount rate applied to the residual value inflow (a positive CF) should be increased to account for the increased risk.
94 If the residual value were included as an outflow (a negative CF) in the cost of leasing cash flows, the increased risk would
95 be reflected by applying a lower discount rate to the residual value cash flow. All other cash flows should be discounted at
96 the original 6% rate.
97 Alter the Residual Discount Rate to see the effect on PV
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99 Year = 0 1 2 3 4
100 Cost of Owning
101 Equipment cost $(1,000)
102 Loan amount $1,000
103 Interest expense $(100) $(100) $(100) $(100)
104 Tax savings from interest $40 $40 $40 $40
105 Principal repayment $(1,000)
106 After tax loan payment $(60) $(60) $(60) $(1,060)
107 Depreciation shield $132 $180 $60 $28
108 Maintenance $(20) $(20) $(20) $(20)
109 Tax savings on maintenance $8 $8 $8 $8 $-
110 Tax on residual value $(40)
111 Cash flow without residual $(12) $60 $108 $(12) $(1,072)
112 Residual cash flow $- $- $- $100
113 PV minus residual @ 6% $(718.48)
114 PV of residual @ 6% $79.21
115 PV of ownership $(639.27) Residual Discount Rate 6.00%
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118 f. 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
119 few sentences, how should you analyze the decision to write or not write the lease?
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121 The lessor owns the equipment when the lease expires. Therefore, residual value risk is passed from the lessee to the
122 lessor. The increased residual value risk makes the lease more attractive to the lessee.
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124 To the lessor, writing the lease is an investment. Therefore, the lessor must compare the return on the lease investment
125 with the return available on alternative investments of similar risk.
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128 g. (1) Assume that the lease payments were actually $300,000 per year, that Consolidated Leasing is also in the 40 percent tax
129 bracket, and that it also forecasts a $100,000 residual value. Also, to furnish the maintenance support, Consolidated would
130 have to purchase a maintenance contract from the manufacturer at the same $20,000 annual cost, again paid in advance.
131 Consolidated Leasing can obtain an expected 10 percent pre-tax return on investments of similar risk. What would
Consolidated's NPV and IRR of leasing be under these conditions?
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134 NPV LEASOR'S ANALYSIS
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136 Year = 0 1 2 3 4
137 Cost of Owning
138 Equipment cost ($1,000)
139 Depreciation shield $132 $180 $60 $28
140 Maintenance ($20) ($20) ($20) ($20)
141 Tax savings on maintenance $8 $8 $8 $8 $0
142 Lease payment $300 $300 $300 $300
143 Tax on lease payment ($120) ($120) ($120) ($120)
144 Residual value $100
145 Tax on residual value ($40)
146 Net cash flow ($832) $300 $348 $228 $88
147 PV @ 6% $21.88
148 IRR 7.35% Discount Rate 6.00%
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150 (2) What do you think the lessor's NPV would be if the lease payments were set at $280,000 per year? (Hint: The lessor's
151 cash flows would be a "mirror image" of the lessee's cash flows.)
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153 With lease payments of $280,000, the lessor’s cash flows would be equal, but opposite in sign, to the lessee’s NAL.
154 Thus, lessor’s NPV = -$22,201.
155 If all inputs are symmetrical, leasing is a zero-sum game.
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158 h. Lewis's management has been considering moving to a new downtown location, and they are concerned that these plans
159 may come to fruition prior to the expiration of the lease. If the move occurs, Lewis would buy or lease an entirely new set of
160 equipment, and hence management would like to include a cancellation clause in the lease contract. What impact would such a
161 clause have on the riskiness of the lease from Lewis's standpoint? From the lessor's standpoint? If you were the lessor, would
you insist on changing any of the lease terms if a cancellation clause were added? Should the cancellation clause contain any
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restrictive covenants and/or penalties of the type contained in bond indentures or provisions similar to call premiums?
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166 A cancellation clause would lower the risk of the lease to the lessee but raise the lessor’s risk. To account for this, the
167 lessor would increase the annual lease payment or else impose a penalty for early cancellation.
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