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 firms brokers. The system also permits customers to call up current quotes on terminals in the lobby.

The equipment costs and, if it were purchased, Lewis could obtain a term loan for the full purchase price at an interest rate. Although the equipment has a useful life, it is classified as a special-purpose computer and therefore falls into the MACRS class. If the system were purchased, a maintenance contract could be obtained at a cost of, payable at the beginning of each year. The equipment would be sold after, and the best estimate of its residual value is . 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 guideline lease on the equipment, including maintenance, for payments of at the beginning of each year. Lewiss marginal federal-plus-state tax rate is. 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 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 firms balance sheet?

(5) What effect does leasing have on a firms capital structure?

B.

(1) What is the present value cost of owning the equipment? (Hint: Set up a time line that shows the net cash flows over the period to, and then find the PV of these net cash flows, or the PV cost of owning.)

(2) Explain the rationale for the discount rate you used to find the PV.

C. What is Lewiss present value cost of leasing the equipment? (Hint: Again, construct a time line.)

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