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:
What is the net advantage to leasing (NAL)? Does your analysis indicate that Lewis should buy or lease the equipment? Explain.
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?
1 | What is the net advantage to leasing (NAL)? Does your analysis indicate that Lewis should buy or lease the equipment? Explain | ||||||
New Equipment Cost | 1000000 | ||||||
Life of the asset | 4 | ||||||
Residual value | 200000 | ||||||
Tax Rate | 40% | ||||||
Loan Interest rate | 10% | ||||||
Annual Rental charge | 260000 | ||||||
After Tax cost of debt | 10%(1-.4) | ||||||
6% | |||||||
Maintenance if not leased | 20000 | ||||||
Calculation of Depreciation | |||||||
Depreciation rate as it is MACRS 3 yrs class | 33.33% | 44.45% | 14.81% | 7.41% | |||
Depreciation Expense | 333300 | 444500 | 148100 | 74100 | |||
Book Value at end | 666700 | 222200 | 74100 | 0 | |||
Schedule of the Cash Flow Statement for Buying and Leasing | |||||||
Yr | 0 | 1 | 2 | 3 | 4 | ||
Buying Option | |||||||
Equipment Cost | -1000000 | ||||||
Loan Amount | 1000000 | ||||||
Interest Expenses | -100000 | -100000 | -100000 | -100000 | |||
Tax Savings from interest | 40000 | 40000 | 40000 | 40000 | |||
Principal Repayment | -1000000 | ||||||
After Tax loan repayment | -60000 | -60000 | -60000 | -1060000 | |||
Depreciation-amt*40% | 133320 | 177800 | 59240 | 29640 | |||
Maintenance | -20000 | -20000 | -20000 | -20000 | |||
Tax Savings-amt*40% | 8000 | 8000 | 8000 | 8000 | |||
Residual value | 200000 | ||||||
Tax on residual value-40% | -80000 | ||||||
-12000 | 61320 | 105800 | -12760 | -910360 | |||
PV Factor | 1 | 0.943 | 0.889 | 0.84 | 0.792 | ||
Total PV | -12000 | 57825 | 94056 | -10718 | -721005 | ||
NPV | -591842.6 | ||||||
Lease Option | 0 | 1 | 2 | 3 | 4 | ||
Lease Payment | -260000 | -260000 | -260000 | -260000 | |||
Tax Savings from lease-40% | 104000 | 104000 | 104000 | 104000 | |||
Net cash flow | -156000 | -156000 | -156000 | -156000 | |||
PV factor @ 6% | 1 | 0.943 | 0.889 | 0.84 | |||
Total PV | -156000 | -147108 | -138684 | -131040 | |||
NPV | -572832 | ||||||
There from the cost comparison it is found that leasing is having a financial advantage over buying option | |||||||
by (591842.6-572832) or $19010.6 | |||||||
2 | 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. | ||||||
Calculation of Cash Flow Statement | |||||||
Yr | 0 | 1 | 2 | 3 | 4 | We can use the most probable or expected cash flow --ie. (50%*0)+(50%*400000)= $ 200000 as the salvage /residual value cash flow in Year 4 | |
Equipment Cost | -1000000 | ||||||
Loan Amount | 1000000 | ||||||
Interest Expense | -100000 | -100000 | -100000 | -100000 | |||
Tax Savings from Interest | 40000 | 40000 | 40000 | 40000 | |||
Principal Repayment | -1000000 | ||||||
After Tax Loan Repayment | -60000 | -60000 | -60000 | -1060000 | |||
Depreciation | 133320 | 177800 | 59240 | 29640 | |||
Maintenance | -20000 | -20000 | -20000 | -20000 | |||
Tax Savings | 8000 | 8000 | 8000 | 8000 | |||
Tax on residual value | -80000 | ||||||
Residual Value | 200000 | ||||||
PV without residual | -12000 | 61320 | 105800 | -12760 | -1110360 | ||
PV factor @ 6% | 1 | 0.943 | 0.889 | 0.84 | 0.792 | ||
PV without residual | -12000 | 57824.76 | 94056.2 | -10718.4 | -879405.12 | ||
PV of residual | 158400 | ||||||
PV without residual | -750242.56 | ||||||
PV of residual | 158400 | ||||||
PV of ownership | -591842.56 |
Lewis Securities Inc. has decided to acquire a new market data and quotation system for its Richmond home office. The sy...
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...
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...
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...
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...
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...
CAN YOU PLEASE SHOW THE EXCEL WORK for the PVs? Thank you FINANCIAL MANAGEMENT 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...
approp cash flows, at what lease payment wold buying? C. Assuming that the alle NI CASE Lewis Securities Inc. has decided to acquire a new market data and quotation s its Richmond home office. The system receives current market prices and other inf tion from several online data services and then either displays the information on or stores it for later retrieval by the firm's brokers. T call up current quotes on terminals in the lobby system for orma he...
Alpha Ltd. considers modernizing its facilities. As part of that process, Alpha has the option of buying the production system for $75,000 or leasing them for 5 years. Alpha would be able to finance 100% of the purchase with a 5 year 7% loan. If purchased, Alpha would also purchase a 5-year maintenance contract for $880 per year, payable at the year-end. Annual lease payments, including maintenance, would cost $18,300. There is not expected to be any residual value at...
Sadik Industries must install $ 1 million of new machinery in its Texas plant. it can obtain a bank loan for 100% of the required amount. Alternatively , a Texas investment banking firm that represents a group of investors believes it can arrange for a lease financing plan. Assume that the following facts apply. 1) The equipment falls in the MACRS 3 year clss 2) Estimated maintenance expenses are $ 50,000 3) The firms's tax rate is 34% 4) If...
Sadik Industries must install $1 million of new machinery in its Texas plant. It can obtain a bank loan for 100% of the required amount. Alternatively, a Texas investment banking firm that represents a group of investors believes it can arrange for a lease financing plan. Assume that the following facts apply. (1) The equipment falls in the MACRS 3 -year class. (2) Estimated maintenance expenses are $50,000 per year. (3) The firm's tax rate is 34%. (4) If the...