Lease vs. Purchase Decision for Lewis Securities' Market Data and Quotation System

Parties to a Lease Transaction: Lessor or Lessee

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 25%. 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? (lessor or lessee)

(2) What are the four primary types of leases, and what are their characteristics?  (finance leases: capital leases, residual value, sale-and-leaseback arrangement/transactions; operating lease; combination leases; net lease; real estate leases, vehicle leases, and synthetic leases and special purpose entity/SPE)

(3) How are leases classified for tax purposes? (non-tax-oriented lease, tax-oriented lease, guideline lease, or true lease, investment tax credit/ITC, The 2017 Tax Cuts and Job Act/TCJA.)

(4) What effect does leasing have on a firm’s balance sheet? (off-balance sheet financing, accounting standards update/ASU 2016-02, capitalize, lease of >1year=liability and an asset, lease liability, right-off use asset, The statements would also report the initial right-of-use asset equal to the initial lease liability,

(5) What effect does leasing have on a firm’s capital structure?

(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? (help: One of the key issues in the lessee’s analysis is the appropriate discount rate. A lease is a substitute for debt, cash flows in a lease analysis are stated on an after-tax basis, and cash flows are known with relative certainty, so the appropriate discount rate is the lessee’s after-tax cost of debt.) What is Lewis’s present value of leasing the equipment? (Hint: Again, construct a timeline.) What is the net advantage to leasing (NAL)? Does your analysis indicate that Lewis should buy or lease the equipment? Explain.  (help: The lessee’s analysis consists basically of a comparison of the PV of leasing versus the PV of owning. The difference in these PV’s is called the net advantage to leasing (NAL).) 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? 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?