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

Jump to Solution
Category:

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

0
0

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.
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’ leaseversus- purchase decision?

Explanation & AnswerSolution by a verified expert

Explanation

The residual value of the equipment will be recorded in the books of the owner and he/she has to bear the high risks of residual value.
The uncertainty of the residual value is adjusted in the agreement through increasing the discount rate, high discounting rate in turn decreases the present values of the residual value and other cash flows which are treated as cash inflows while determining the cost of owning the equipment.
The lower cash inflows will definitely increase the cost of owning the equipment and make the leasing more attractive.

Verified Answer

In a case where the lessee acquires the asset after the end of lease agreement, the residual value of equipment is considered in calculating the cost of leasing in the books of the lessee.
In the concerned case, if the company purchases the equipment, the company has to bear the uncertainty of residual value. The risk is adjusted by increasing the discount rate which decreases the present value of equipment's residual value. The residual value is treated as an inflow while calculating the cost of owning and therefore, the lower residual value will increase the cost of owning the equipment. Thus, leasing the equipment will become favourable over owning it.

Purchase this answer to view it. $5
Login/Sign up for free, load your wallet instantly using PayPal or cards and purchase this solution to view it.

Looking for the solution to this or another homework question?

If you need essay writing assistance or homework solutions, log in or sign up for a free account and ask our writers any homework question.