Should the cancelation clause contain provisions similar to call premiums or any restrictive covenants and/or penalties of the type contained in bond indentures? Explain your answer.

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Should the cancelation clause contain provisions similar to call premiums or any restrictive covenants and/or penalties of the type contained in bond indentures? Explain your answer.

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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.
h. Lewis’s management has been considering moving to a new downtown location, and they are concerned that these plans may come to fruition prior to the equipment lease’s expiration. If the move occurs then Lewis would buy or lease an entirely new set of equipment, so management would like to include a cancelation clause in the lease contract. What effect would such a clause have on the riskiness of the lease from Lewis’s standpoint? From the lessor’s standpoint? If you were the lessor, would you insist on changing any of the other lease terms if a cancelation clause were added? Should the cancelation clause contain provisions similar to call premiums or any restrictive covenants and/or penalties of the type contained in bond indentures? Explain your answer.

Explanation & AnswerSolution by a verified expert

Explanation

A cancellation clause in the lease agreement lowers the risk of company L, that is the lessee as it is no longer bound to pay the lease payments for the whole term of the agreement. In the adverse situations, when the company wants to cancel the lease contract, it can cancel anytime.
On the other hand, a cancellation clause increases the risk of lessor as the lessor has to bear the risk of uncertainty of the contract as well as the risk of high residual value.
However, the lessor can mitigate the high risk by deliberately increasing the lease payments or putting restrictions or penalties on the use of cancellation clauses.
The lessor is able to bear the high risk of uncertainty and residual value when the lease gets cancelled by leasing the equipment to some other party after cancellation and diversifying the high risk in the advantageous portfolios.

Verified Answer

From the standpoint of the Company L which is the lessee, the cancellation clause will decrease the riskiness of the lease agreement because the lessee can cancel the agreement anytime whenever the leased agreement is generating losses or the company wants upgraded equipment.
However, from the standpoint of the lessor, inclusion of a cancellation clause will increase the risk because the lessee can cancel the agreement anytime during its time period and harm the expected lease payments and interest income of the lessor. The lessor will bear the risk of residual value as well as of the uncertainty of the lease payments.
If a cancellation clause is added in the lease agreement, the lessor may take the following steps to mitigate the effects of the risk:

Increase the amount of lease payments.
Fix a time upto which the lessee cannot avail the benefit of cancellation.
Imposing penalty on cancellation of agreement.

No, the cancellation clause should not contain any penalties or restrictions as the lessor manages the uncertainty of lease agreement through the acquired expertise at disposing of used equipment in case it gets cancelled and easily bears high risks through diversified portfolios.

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