The lessee compares the present value of owning the equipment with the present value of leasing it. Now put yourself in the lessor’s shoes. In a few sentences, how should you analyze the decision to write or not to write the lease?

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The lessee compares the present value of owning the equipment with the present value of leasing it. Now put yourself in the lessor’s shoes. In a few sentences, how should you analyze the decision to write or not to write the lease?

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ewis 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.
f. The lessee compares the present value of owning the equipment with the present value of leasing it. Now put yourself in the lessor’s shoes. In a few sentences, how should you analyze the decision to write or not to write the lease?

Explanation & AnswerSolution by a verified expert

Explanation

The lease agreement is similar to an investment proposal for a lessor. The lessor chooses a lease that provides maximum return out of the various lease options having the same level of risk so as to maximise the interest income along with the lease payments. Returns to a lessor includes the interest expense paid by the lessee on behalf of the equipment apart from the lease payments. The lessor also compares the return on the agreement with its cost of capital and accepts the proposal if it is earning a higher return than the cost of capital.

Verified Answer

The lessor considers a lease as an investment proposal. So, he/she analyses the lease on the basis of returns from investment and chooses to lease the equipment with maximum return out of the various lease options having the same level of risk. So, a lessor writes the lease when the returns from the proposal are higher than its cost of capital and as per the expectations of the lessor.

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