1. Martha Millon, financial manager for F&C Ltd. has been asked to perform a lease versus buy analysis on a new computer system. The computer system costs $1,200,000 and if it is purchased, F&C Ltd could obtain a term loan for the full amount at an interest rate of 10% per annum. The loan would be repaid over the 4 year life of the computer, with equal annual instalments of principal and interest payments made at the end of each year. F&C Ltd plans to depreciate the computer system using straight line method over its useful life of 4 years. If the computer is purchased, a maintenance contract must be obtained at a cost of $25,000 per year, payable at the beginning of each year. Due to the rapid changes in technology, after 4 years, the computer will be sold, and Millons best estimate of the residual value at that time is $125,000.

As an alternative, National Leasing is willing to offer a 4-year lease on the computer system, including maintenance for four (4) payments of $340,000 payable at the beginning of each year. F&C Ltds marginal tax rate is 33 %.

You are required to help Martha Millon conduct her analysis by answering the following:

1. What is leasing? Why leasing is considered an attractive form of funding?

(Word limit 300)

(3 marks)

2. Evaluate the alternatives, leasing versus purchasing the computer system using the present value (PV) approach. (Use the financial calculator for this purpose and detail the steps taken)

(10 marks)

3. Explain briefly the rationale behind your choice of the alternative in (b) above. (Word limit 100)

(2 marks)

4. Millon knows that her firm has been considering moving its headquarters to a new location for some time. She is concerned that these plans may come to fruition before the expiration of the lease. If the move occurs, the company would obtain completely new computers and hence Millon would like to include a cancellation clause in the lease contract. What effect would a cancellation clause have on the riskiness of the lease? (Word limit: 100)