Question

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 40%. 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?

2. What are the five 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?

Using complete sentences and academic vocabulary, please answer questions a through f. Please don't copy from other sources. Thank you

Answer 1

Answer 1) Lease is a contract between two parties i.e. a lessor, the owner of the asset and a lessee, the user of the asset.

Answer 2) Five primary types of leases and its characteristics:

• Operating lease: It sometimes called as service lease, provides for both financing ans maintenance. It is short term, cancellable lease agreements. In this risk of obsolescence is borne by the lessor. Convenience and instant services are the hallmarks of operating leases. In this assets have short life between 3 to 5 years. It is generally responsible for the maintenance and insurance of the asset. It also have option to cancel the lease.Naturally, the shorter the lease period higher the risk of obsolescence, the higher will be the lease rentals.
• Financial lease: These type of lease is long term, non cancellable lease contracts. Financial lease amortize the cost of the asset over the term of lease. It is also called as capital or full payout lease. In this lessor buys the asset identified by lessee from the manufacturer and signs a contract to lease it ot to the lessee. The maintenance and insurance is responsibility of the lessee. The lessee bears the risk of the obsolescence.
• Sale and lease back: It is special financial lease agreement in which the lessee first sells asset owned by him to the lessor and then leases it back from the lessor. This provides liquidity as well as possible tax gains to the lessee.
• Leveraged lease: It involves lessor, lessee and the financier. Lessor provides equity equal to about 25 % of the asset cost while the remaining amount is provided by the financier mainly as loan. Leveraged lease is popular method of financing expensive assets.
• Direct lease: It is the mix of operating and finance lease on a full payout basis and provides for the purchase option to the lessee.

Answer 3) A guideline lease is a lease that meets all of the IRS requirement for a genuine lease. A guideline lease is often called a tax-oriented lease. If a lease meets the IRS guidelines, the IRS allows the lessor to deduct the asset's depreciation and allows the lessee to deduct the lease payments

Answer 4) If the lease is classified as a capital lease, it is shown directly on the balance sheet. If it is an operating lease, it is only listed in the footnotes.

Answer 5) Leasing is a substitute for debt financing, so leasing increases a firm's financial leverage.