Over the past few years, officials in Florida and other states that rely primarily on deep wells for drinking water have become aware of a potentially serious problemthe pollution of aquifers by the unrestrained use of fertilizers and pesticides. The results of a study conducted by the United States Geological Survey showed that while the primary aquifer underlying Florida is not yet contaminated, one chemical commonly found in agricultural pesticides has caused extensive contamination of wells that tap water-bearing strata near the surface. To combat this potentially widespread problem, officials in Florida and elsewhere are lobbying for strict environmental regulation of commercial fertilizers and pesticides. As a result, companies specializing in agricultural chemicals have been working furiously to supply new products that will not be banned under the proposed regulations. Environmental Sciences, Inc., a regional producer of agricultural chemicals based in Orlando, recently developed a pesticide that meets the new regulations. Now the firm must acquire the necessary equipment to begin production. The estimated internal rate of return (IRR) of this project is 24percent and the project is judged to have low risk. Environmental Sciences uses an after-tax cost of capital of 11 percent for relatively low-risk projects, 13 percent for those of average risk, and 15percent for high-risk projects; so this low-risk project passed the hurdle rate with flying colors. The production-line equipment has an invoice price of $1,375,000, including delivery and installation charges. It falls into the modified accelerated cost recovery system (MACRS) five-year class, with current allowances of 0.20, 0.32, 0.19, 0.12, 0.11, and 0.06 in Years 16, respectively. Environmentals effective tax rate is 40 percent. The manufacturer of the equipment will provide a contract for maintenance and service for $75,000 per year, payable at the beginning of each year, environmental Sciences buys the equipment. Regardless of whether the equipment is purchased or leased, Susan Baker, the firms financial manager, does not think it will be used for more than four years, at which time Environmen-tals current building lease will expire. Land on which to construct a larger facility has already been acquired, and the building should be ready for occupancy at that time. The new facility will be designed to enable Environmental to use several new production processes that are currently unavailable to it, including one that will duplicate all processes of the equipment now being considered. Hence, the current project is viewed as a bridge to serve only until the permanent equipment can become operational in the new facility four years from now. The expected useful life of the equipment is eight years, at which time it should have a zero market value, but the residual value at the end of the fourth year should be well above zero. Susan generally assumes that assets salvage values will be equal to their tax book values at any point in time, but she is concerned about that assumption in this instance.

Currently, the company has sufficient capital, in the form of temporary investments in marketable securities, to pay cash for the equipment and the first years maintenance. Susan estimates that the interest rate on a 4-year secured loan to buy the equipment would be 11 percent, but she has decided to draw down the securities portfolio and pay cash for the equipment if it is purchased. Oceanside Capital, Inc. (OSC), the leasing subsidiary of a major regional bank, has offered to lease the equipment to Environmental for annual payments of $435,000, with the first payment due upon delivery and installation and additional payments due at the beginning of each succeeding year of the 4-year lease term. This price includes a service contract under which the equipment would be maintained in good working order. OSC would buy the equipment from the manufacturer under the same terms that were offered to Environmental, including the maintenance and service contract. Like Environmental, OSC generally assumes that the most likely residual value for equipment of this type is the tax book value at the end of the lease term. Some OSC executives think, however, that the residual value, in this case, will be much higher because of the expanding nature of the business. OSC is not expected to pay any taxes over the next 4 years, because the firm has an abundance of tax credits to carry forward. Finally, OSC views lease investments such as this as an alternative to lending, so if it does not write the lease, it will lend the $1,375,000 that would have been invested in the lease to some other party in the form of a term loan that would earn 11 percent before taxes.Susan Baker has always had the final say on all of Environmentals lease-versus-purchase decisions, but the actual analysis of the relevant data is conducted by Environmentals assistant treasurer, Tom Linenberger. Traditionally, Environmentals method of evaluating lease decisions has been to calculate the present value cost of the lease payments versus the present value of the total charges if the equipment is purchased. However, in a recent evaluation, Susan and Tom got into a heated discussion about the appropriate discount rate to use in determining the present value costs of leasing and purchasing. The following points of view were expressed:(1)Susan argued that the discount rate should be the firms weighted average cost of capital. She believes that a lease-versus-purchase decision is in effect a capital budgeting decision, and as such, it should be evaluated at the companys cost of capital. In other words, one method or the other will provide a net cash savings in any year, and the dollars saved using the most advantageous method will be invested to yield the firms cost of capital. Therefore, the weighted average cost of capital is the appropriate opportunity rate to use in evaluating lease-versus-purchase decisions. (2)Tom, on the other hand, believes that the cash flows generated in a lease-versus-purchase situation are more certain than are the cash flows generated by the firms average project. Consequently, these cash flows should be discounted at a lower rate because of their lower risk. At present, the firms cost of secured debt reflects the lowest risk rate to Environmental Sciences. Therefore, 11 percent should be used as the discount rate in the lease-versus-purchase decision. To settle the debate, Susan and Tom asked Environmentals CPA firm to review the situation and to advise them on which discount rate was appropriate. This led to even more confusion because the firms accountants, Michelle Nobelitt and Bill Orr, were also unable to reach an agreement on which rate to use. Michelle agreed with Susan that the discount rate should be based on the firms cost of capital, but on the grounds, that leasing is simply an alternative to other means of financing. Leas-ing is a substitute for financing, which is a mix of debt and equity, and it saves the cost of raising capital; this cost is the firms weighted average cost of capital. Bill, however, thought that none of the discount rates mentioned so far adequately accounted for the tax effects inherent in any capital budgeting decision, and he suggested using the after-tax cost of secured debt. In the last lease-versus-purchase decision, the firms weighted average cost of capital (13percent) was used, but now Susan is uncertain about the validity of this procedure. She is beginning to lean toward Bills alternative, but she wonders if it would be appropriate to use a low-risk discount rate for evaluating all the cash flows in the analysis. Susan is particularly concerned about the risk of the expected residual value. While the company is almost certain of the other cash flows and the tax shelters, the salvage value at the end of the fourth year is relatively uncertain, having a distribution of possible outcomes that makes its risk comparable to that of the average capital budgeting project undertaken by the firm. She is also concerned that using a discount rate based on the after-tax cost of a secured loan might be inappropriate when the funds used to purchase the equipment would come from internal sources. Perhaps the cost of equity capital also deserves consideration, because the funds could be used to increase the next quarterly dividend payment.To settle all the disputes, the parties to the lease-versus-buy analysis agreed that an outside consultant should be hired to conduct the analysis. Assume you are that consultant and the firm have provided you with the following list of questions.

PART A: Lessees Analysis

1. The conventional format for analyzing lease-versus-purchase decisions assumes that the money to buy the equipment will be obtained by borrowing. In this case, however, Environ-mental has sufficient internally generated capital, held in the form of marketable securities, to buy the equipment outright. What impact does this fact have on the analysis?

2. Should Environmental lease or purchase the equipment? Assume that if the decision is made to purchase the equipment, it will be sold for its book value on the first day of Year 5, hence the full Year 4 depreciation can be taken. Further, use the 11.0 percent before-tax (6.6 per-cent after-tax) cost of debt as the residual value discount rate. (Hint: Use Part A of Table 1as a guide.)

3. Justify the discount rate you used in the calculation process. Now assume that Susan wants you to adjust the analysis to reflect differential residual value risk. What impact does this have on Environmentals lease-versus-purchase decision? (Hint: The 13 percent weighted average cost of capital used to evaluate average-risk projects is an after-tax cost.)

4. a. Based on the information given in the case, would you classify this lease as a financial lease or as an operating lease? For accounting purposes, a lease is classified as a financial lease, hence must be capitalized and shown directly on the balance sheet, if the lease contract meets any one of the following conditions:(1) The lessee can buy the asset at the end of the lease term for a bargain price. (2) The lease transfers ownership to the lessee before the lease expires. (3) The lease lasts for 75 percent or more of the assets estimated useful life. (4) The present value of the lease payments is 90 percent or more of the assets value. b. Does the differential accounting treatment of operating versus financial leases make comparative financial statement analysis more difficult for outside financial analysts? If so, how might analysts overcome the problem?

5. In some instances, a company might be able to lease assets at a cost less than the cost the firm would incur if it financed the purchase with a loan. If the equipment represented a significant addition to the lessees assets, could this affect its overall cost of capital, hence the capital budgeting decision that preceded the lease analysis? Would this affect capital budgeting decisions related to other assets? Explain.

6. Now assume that Susan estimates the residual value could be as low as $0 or as high as$467,500. Further, she subjectively assigns a probability of occurrence of 0.25 to the extreme values and 0.50 to the base case value, $233,750. Describe how Susans estimates could be incorporated into the analysis. If you are using the Lotus model, calculate Environ-mentals net advantage to leasing (NAL) at each residual value. What is the expected NAL?(For this analysis, assume a 6.6 percent after-tax discount rate on all cash flows.)PART B: Lessors Analysis

7. Now evaluate the proposed lease from the point of view of the lessor, Oceanside Capital, Inc. Assume that the residual value is equal to the book value at the end of the fourth year, and use an 11 percent after-tax discount rate for all cash flows. Are the current terms favor-able to OSC? (Hint: Use Part B of Table 1 as a guide.)PART C: Combined Analysis

8. Based on a 4-year use of the asset, a 6.6 percent after-tax discount rate on the cash flows of the lessee, and an 11 percent after-tax discount rate on the cash flows of the lessor (that is, the original conditions), you should have found that the lease is advantageous to both Environmental Sciences and OSC. Is there a range of lease payments that would be acceptable to both the lessor and the lessee? At which end of the range do you think the actual payment would be set? If you are using the Lotus model, specify the actual range of payments.

9. There is a possibility that Environmental will move to its new production facility earlier than anticipated, hence before the expiration of the lease. Thus, Susan is considering askingOSC to include a cancellation clause in the lease contract. What impact would a cancellation clause have on the riskiness of the lease to the Environmental? How would it affect the risk toOSC? If you were OSCs leasing manager, would you change the lease terms if a cancellation clause were added? If so, what changes might be made?

10. Leases are sometimes written so that the lessee makes payments at the end of each year rather than in advance. If the lessor structured the analysis with deferred payments, how would this affect (a) the NAL from the lessees standpoint and (b) the rate of return earned by the lessor? Could the lease payments be adjusted, if they were made on a deferred basis, to produce the same NAL as existed when the payments were made in advance?

11. Assume now that OSC has no tax credits to carry forward, hence is in the 40-percent tax bracket. Also, assume that both parties to the lease estimate a $233,750 residual value and discount it at a 6.6 percent after-tax discount rate. What do you think would happen to OSC's NPV under these conditions? If you are using the Lotus model, do the calculation.

12. What effect do you think Environmentals tax rate has on its lease-versus-purchase decision? If you are using the Lotus model, find Environmentals NAL at tax rates of 0, 10, 20,30, 40, 50, and 60 percent. Explain your results.