Seattle Cancer Center is a nationally known not-for-profit inpatient and outpatient facility dedicated to the prevention and treatment of cancer. Specific treatment services include surgery, chemotherapy, bone marrow transplantation, radiation therapy, and photodynamic therapy.

For the past 10 years, Seattle has been working diligently to perfect noninvasive brain surgery techniques. One technique, Gamma Knife radiosurgery, was developed in the 1950s and 1960s by Dr. Lars Leksell, a prominent Swedish neurosurgeon. The first patient treatment site was opened in 1968 in Stockholm, Sweden, while the first site in the United States was established in Pittsburgh, Pennsylvania, in 1977.

The Gamma Knife uses 201 separate radiation sources to treat certain brain cancers. Each radiation beam is weak and hence does not damage normal brain tissue, but when the separate beams are focused on a single point by a collimator helmet, the equipment delivers a dosage sufficient to be highly effective. The Gamma Knife is especially useful in the treatment of arteriovenous malformations, but it can also be used to treat certain types of benign tumors and even some small malignant lesions. The primary clinical benefit of the procedure is the significant reduction in the risk associated with traditional surgical procedures, in which the morbidity and mortality rates are substantial, especially for patients with deep lesions. In addition to treating cancer, it can treat functional disorders such as Parkinsons disease tremors and the pain that results from trigeminal neuralgia. (For more information about the Gamma Knife, including an informative video on Gamma Knife surgery, see the manufacturers website at http://gammaknife.com.)

The procedure calls for a team approach, including a neurosurgeon, radiation physicist, radiologist, and radiation therapist. The neurosurgeon selects the patients appropriate for the procedure and performs the stereotactic process required to localize the target area. The radiation physicist works with a computer program to calculate the appropriate dosimetry, while the radiologist performs a computed tomography scan, a magnetic resonance imaging scan, an angiogram, or a combination of the three to help the neurosurgeon localize the lesion.

The dosimetry calculations are especially complex. Because differing thicknesses of skull and brain will attenuate the beams to varying degrees, the amount of radiation applied is highly dependent on where the lesion is located and the size and shape of the patients skull. The actual application of the radiation takes between 20 minutes and 2 hours, and the patient is generally released after only a short period of observation.

Seattle plans to acquire a new Gamma Knife to replace its current model. The equipment has an invoice price of $3 million, including delivery and installation charges, and it falls into the MACRS (modified accelerated cost recovery system) five-year class, with current allowances of 0.20 in Year 1, 0.32 in Year 2, 0.19 in Year 3, 0.12 in Year 4, 0.11 in Year 5, and 0.06 in Year 6. The manufacturer of the equipment will provide a maintenance contract for $100,000 per year, payable at the beginning of each year, if Seattle buys the equipment. Furthermore, the purchase could be financed by a four-year, simple-interest, conventional (taxable) bank note that would carry an interest rate of 9 percent.

Regardless of whether the equipment is purchased or leased, Seattles managers do not think the new Gamma Knife will be used for more than four years, at which time Seattle plans to open a new radiation therapy facility. 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 is designed to enable Seattle to use several new radiosurgery procedures. Thus, the Gamma Knife replacement is viewed as a bridge, to serve only until the new facility is ready. The expected physical life of the equipment is 10 years, but medical equipment of this nature is subject to unpredictable technological obsolescence.

After considerable debate among Seattles managers, they concluded that there is a 25 percent probability that the residual (salvage) value after four years will be $800,000; a 50 percent probability that it will be $1.2 million; and a 25 percent probability that it will be $1.6 million, which makes the residual value quite risky. If the residual value is judged to have high risk, any risk analysis would add a 4-percentage-point adjustment to the base discount rate used in the base case lease analysis to obtain the appropriate rate for the residual value.

GB Financing, a leasing company that is partially owned by the Gamma Knife manufacturer, has presented an initial offer for Seattle to lease the equipment for annual payments of $675,000, with the first payment due on delivery and installation and subsequent payments due at the beginning of each succeeding year of the four-year lease term. This rental price includes a service contract under which the equipment would be maintained in good working order. GB Financing would buy the equipment from the manufacturer under the same terms that were offered to Seattle, and GB Financing would have to enter into a maintenance contract with the manufacturer for $100,000 per year. (For more information on leasing healthcare equipment, see the CSI Leasing website at www.csileasing.com/solutions/healthcare-equipment-leasing/.)

Unlike Seattle, GB Financing forecasts a $1.6 million residual value. Its estimate is based on the following facts:

There is no technology on the horizon that would make the Gamma Knife obsolete.

The Gamma Knife has a physical life estimated to be two and a half times longer than the

four-year lease term.

GB Financing is more skilled than Seattle in selling used equipment, especially the

Gamma Knife.

GB Financings federal-plus-state tax rate is 30 percent, and, if the lease is not written, it

could invest the funds in a four-year term loan of similar risk yielding 8 percent before taxes.

Randall Rhee Williams, Seattles chief financial officer, has the final say on all the firms lease- versus-purchase decisions, but the actual analysis of the relevant data will be conducted by Seattles capital funds manager, Vanessa Seagle. In the past, Randall and Vanessa have agreed on analytical methodologies, but in discussing this lease analysis, they ended up in a heated discussion about the appropriate discount rate to use in the analysis.

Randall argued that the cash flows associated with performing stereotactic radiosurgery are very uncertain. He is convinced that payers are not going to be nearly as generous in the future as they

have been in the past in reimbursing for such procedures, so the revenue stream is highly speculative. Accordingly, he thinks that a high discount rate should be used in the analysis. Vanessa, on the other hand, believes that leasing is a substitute for other financing, which is a blend of debt and equity capital. Consequently, she asserts that the lease-analysis cash flows should be discounted at Seattles corporate cost of capital, 10 percent. However, it is possible that both Randall and Vanessa are wrong.

Both Randall and Vanessa believe that lessees should not blindly accept the first offer made by potential lessors but should conduct a complete analysis from the viewpoint of both parties and then, using this knowledge, negotiate the best deal possible. Thus, knowing the range of lease payments that is acceptable to both parties is important.

There is a possibility that Seattle will move to its new radiation facility earlier than anticipated and hence before the expiration of the lease. Furthermore, if the neurosurgeonthe primary user of the Gamma Knifeleaves the staff and is not immediately replaced, the equipment would be useless. Thus, Randall is considering asking GB Financing to include a cancellation clause in the lease contract. Under such a clause, Seattle would be able to return the equipment at any time during the lease term after giving a minimum 30-day notice. Before negotiations begin, Seattle must assess the impact of such a clause on the riskiness of the lease to both parties and any consequences the clause might have on the terms of the lease.

In addition, Randall is aware that many lessors are now writing per-procedure leases, in which the lease payment is tied to the number of procedures performed rather than a fixed amount. He wonders what the consequences would be for both the lessee and the lessor if a per-procedure lease were used instead of a conventional lease. GB Financing has quoted a per-procedure lease rate of $7,000 for an expected annual volume of 100 procedures. However, previous experience at Seattle indicates that volume could easily be as low as 70 procedures or as high as 130 procedures. Considering current charges and reimbursement rates, Seattle expects to realize a net revenue per procedure of roughly $10,000.

Seattles leadership has discussed obtaining tax-exempt financing for the Gamma Knife should it be purchased. If it is purchased, the cost of tax-exempt (municipal) debt would be only 5 percent. To complicate matters, Seattle currently has more than $5 million in excess funds invested in marketable securities earning 3 percent. These funds, rather than debt financing, could be used to purchase the equipment.

GB Financing would probably obtain a $1.5 million simple-interest loan to leverage the lease. The terms of this loan have not been finalized, but the bank has indicated that the interest rate would be in the range of 7 to 9 percent. Such leveraging could affect GB Financings ability to negotiate lease payments, so understanding the impact of leveraging from the lessors perspective is important.

As a baseline, assume all cash flows have the same risk. (For the lessee, use the same value for the loan interest rate and residual value discount rate. For the lessor, use the same value for the opportunity cost rate and residual value discount rate). Ignore the leveraged lease analysis.

a. Should the Center lease the equipment? Should GBF write the lease?

b. Who is getting the better deal? Explain.

c. What is the maximum lease payment that the Center would be willing to pay? What is the minimum lease payment that GBF would be willing to accept?

d. What factors influence whether the actual lease payment will be closer to the Centers maximum lease payment or GBFs minimum lease payment?

2. This lease is attractive to both parties because there is asymmetry of inputs between lessee and lessor.

a. What are these asymmetries?

b. What would be the result if there were no asymmetries? Use the model to prove it.