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 25%. You have been asked to analyze the lease-versus-purchase decision and, in the process, to answer the following questions.

1. • (1)What is the present value of owning the equipment? (Hint: Set up a time line 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?

2. What is Lewis’s present value of leasing the equipment? (Hint: Again, construct a time line.)

3. What is the net advantage to leasing (NAL)? Does your analysis indicate that Lewis should buy or lease the equipment? Explain.

4. 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?

Answer 1

Bookl - Microsoft Excel Page Layout Formulas Data Review View Home Insert * Cut La Copy Paste Format Painter Clipboard E20 A B Calibri B I = = = E D - 11 - A A U - - -A Font D Wrap Text E F Merge & Center - Alignment - :. E General $ % , Number 1 Conditional Format Formatting as Table Styles - } Insert Delete Format Cell Styles Autosum - 47 Sort & Find & 2 Clear Filter Select Editing Cells C D F G H I J L. M N O Q R S T U The following table summarizes the calculation of cash flows under this Answer 1 alternative Period 0 1 2 3 4 Loan repayment (A) 0 250000 250000 250000 | 250000 maintanance costs 20000 20000 20000 20000 0 (B) 200000 100000 200000 75000 200000 200000 50000 | 25000 20000 320000 295000 270000 225000 depreciation (C) interest expense (D) total tax deductions (E) = B + C +D tax @ 25% (F) = E * 0.25 net cash flows (G) = A +B-F 5000 80000 73750 67500 56250 15000 190000 196250 202500 193750 Depreciation is calculated on straight-line basis using the 4-year useful life .e. ($1000000-$200000)/4 200000 Interest expense are calculated in the following debt amortization table: Total Principal Opening Closing Period repaymen Interest repaymen principal principal 19 20 0 1 200 0 1 100 0 1 200 1000000 l zonnon 1 100 K Sheet1 Sheet2 Sheet3 ™ Ready O 90% - UF - t il 5:38 PM 3/27/2020

Bookl - Microsoft Excel Insert Page Layout Formulas Data Review View Home * Cut AutoSum - A = = = Eg Copy Format Painter Calibri B I Paste U - 11 - A A D- -A Font E D Wrap Text E Merge & Center - Alignment General $ - % , Number 8.09 Conditional Format Formatting as Table Styles Cell Styles Insert Delete Format 2 Clear Sort & Filter Editing Find & Select Cells Clipboard E20 A B C D н K L M N O P Q R S T U Interest expense are calculated in the following debt amortization table: Total Principal Opening Closing Period repaymen Interest repaymen principal principal t 1000000 | 0 0 0 1000000 1000000 350000 100000 250000 750000 750000325000 75000 250000 500000 500000 300000 50000 250000 250000 250000 275000 25000 250000 0 Now, we have to calculate the present value of cash outflows under both the s using the after-tax cost of debt which is 7.5% = 10% (1-0.25) (negative value represents cash inflows and it is assumed that at the end of fourth year, the equipment will be sold at $200,000) Period 0 1 2 3 4 net cash flows (under purchase 15000 190000 196250 202500 193750 decision) -200000 Present value factor 1 0.93 0.87 0.80 0.75 Present value of the 15000 176744 169822 163005145080 cash flows Net present value Sheet1 Sheet2 Sheet3 Ready DU 90% OF - t il 5:39 PM 3/27/2020

Bookl - Microsoft Excel Insert Page Layout Formulas Data Review View Home * Cut AutoSum - A Eg Copy Calibri B I = = = E D E F Wrap Text Merge & Center - General $ % Paste E , :. - 11 - A A U - - -A Font foo Insert Delete Format Conditional Format Formatting as Table Styles Cell Styles 2 Clear Sort & Find & Filter Select Editing Alignment Number Format Painter Clipboard E20 A B Cells C H K M N O Q R S LT Answer 2 Under leasing decision: Annual cash out flows of leasing (Year 1 to Year 4) = $260,000 *(1 - 25%) 195000 Period 1 | 2 | 3 | Net cash flows under leasing decision 195000 195000 195000 195000 Present value factor Net present value 3.60 | 702102.5 since it is not lease and buy back transaction, it is assumed that after 4th year, the equipment is returned to the vendor. Answer 3 net advantage to leasing (NAL) In this case, net advantage to leasing (NAL) is negative since the outflows are lesser in the purchase decision. net advantage to leasing (NAL)= NPV of cash outflows under Puchase decision - NPV of cash outflows under Leasing decision -32452.19 -32452.19 Which decision to be made by the company: Sheet1 Sheet2 Sheet3 Ke Ready BDU 90% OF - t il 5:39 PM 3/27/2020