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?

$(3)$ 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?

b$.(1)$ 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?

c$.$ What is Lewis's present value 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.

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?