What are some other issues in lease analysis?

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What are some other issues in lease analysis?

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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.
i. What are some other issues in lease analysis?

Explanation & AnswerSolution by a verified expert

Explanation

The issues in a lease analysis are:

The estimated residual value of the asset fluctuates due to inflation or any other market forces. High competition decreases the leasing rates upto the point where residual values are completely recognised in the lease contract.
A lessee might choose purchasing the equipment over leasing as investment made to purchase the equipment will benefit the lessee in availing investment tax credit. The investment tax credit is the deduction of a certain percentage of investment cost from taxes of the firm. However, the tax differentials between the lessee and the lessor makes leasing attractive.
A lease agreement with a cancellation clause enhances the lessor’s risk as the lessee can cancel the lease anytime during the agreement, high risk is adjusted in the discounting rate and that in turn, reflects lower present value of residual cash flows.

Verified Answer

The issues in a lease analysis are:

The higher residual value of the asset makes a lease less attractive.
An investment tax credit makes the lessee to choose owning the equipment over leasing it. However, the tax differentials between the lessee and the lessor makes leasing attractive.
The inclusion of cancellation clause in the lease agreement enhances the risk of lessor.

Apart from the numerical evaluation which indicates owning the asset is more attractive than leasing, the leasing will still be beneficial due to lower risks, estimated project life, maintenance costs, The leasing also mitigates the risks for the lessor as the risks are reduced due to portfolio risk investment.

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