What effect does leasing have on a firm’s balance sheet?

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Mini Case – Lease Financing
The purpose of this assignment is to explain core concepts
related to lease vs. purchase and tactical financial decisions.
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.
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? (Finance/capitalized
leases, Operating Leases, Sales Leases, Manufacturing leases.)

(3) How are leases classified for tax purposes? (Non-tax-oriented lease and Tax-oriented
lease, also known as a guideline lease or a true lease)

(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 = 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 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 to write the lease?

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