What effect does leasing have on a firm’s capital structure?

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What effect does leasing have on a firm’s capital structure?

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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.
a. (1) Who are the two parties to a lease transaction?

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.
a. (2) What are the four primary types of leases, and what are their characteristics?

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.
a. (3) How are leases classified for tax purposes?

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.
a. (4) What effect does leasing have on a firm’s balance sheet?

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.
a. (5) What effect does leasing have on a firm’s capital structure?

Explanation & AnswerSolution by a verified expert

Explanation

The parties to a lease transaction are the lessor and the lessee where the lessor is the owner of the asset and provides it to the lessee on rent or lease to use it for a definite time period and adhere to the terms and conditions mentioned in the agreement.
Lessee is the other party total the contract who uses the lessor's asset in lieu of a periodic compensation. Both the parties must accept the terms of agreement to make it a valid contract.

Verified Answer

The parties to a lease transaction are:

Lessor: A lessor is the party in the agreement who owns the asset and that is leased or rented to another party for lease rentals.
Lessee: A lessee is the other party who acquires the asset on lease and pays for its use to the lessor.

Explanation

The primary types of leases are:

Financial lease- A financial lease is an agreement where the lessee is allowed to use the asset during the agreement and is given the ownership of the asset by the end of the lease term.
Operating lease- The operating lease allows the lessee to use the lessor’s asset during the agreement without transferring the ownership of the asset at the end of the lease term.
Combination lease- A combination lease contains the mixed features of the operating as well as the financial lease.The combined leases generally contain customized terms and conditions to meet the desired obligations of the parties which neither of the two types of leases can fully fulfil.
Sale and leaseback-A sale-and-leaseback transaction includes selling of the asset by its owner to another party and then leasing it back from its purchaser. The original owner ceases to own the asset but utilizes it under the lease agreement.

 
The characteristics of a financial lease are:

The lessee is given the ownership of the asset at the end of lease agreement at its residual value.
The lessee bears the administrative and other maintenance cost of equipment during the agreement.
Financial lease period covers most of the economic life of the equipment.

 
The characteristics of an operating lease are:

The lessee is not given the ownership of the equipment at the end of lease agreement. The lessee uses the equipment only during the period of agreement.
The lessor has to bear the administrative and other maintenance cost of equipment during the agreement.
An operating lease term ends much before the economic life of equipment.

 
The characteristics of a combination lease are:

Combined lease contains the mixed features of both financial lease and operating lease.
Combined leases are created to meet the different demands of customers which either of the above two leases cannot fulfil.

 
The characteristics of a sale and leaseback are:

The owner of the equipment sells the asset to another firm.
The previous owner who sells the asset enters into a lease agreement with the new owner and uses the equipment without having ownership rights.

Sample Response

The primary types of leases are:

Financial lease- A financial lease is an agreement where the lessee is allowed to use the asset during the agreement and is given the ownership of the asset by the end of the lease term.
Operating lease- The operating lease allows the lessee to use the lessor’s asset during the agreement without transferring the ownership of the asset at the end of the lease term.
Combination lease- A combination lease contains the mixed features of the operating as well as the financial lease.The combined leases generally contain customized terms and conditions to meet the desired obligations of the parties which neither of the two types of leases can fully fulfil.
Sale and leaseback-A sale-and-leaseback transaction includes selling of the asset by its owner to another party and then leasing it back from its purchaser. The original owner ceases to own the asset but utilizes it under the lease agreement.

 
The characteristics of a financial lease:
Under a financial lease, the lessee is given the ownership of the asset at the end of the agreement. Moreover, the lessee has to bear the administrative and other maintenance cost of the asset during the term of the lease. The time period of  a financial lease is equivalent to almost the whole estimated life of the asset.
The characteristics of an operating lease:
Under an operating lease, the lessee is not given the ownership of the asset at the end of the lease term and the lessor bears the administrative and other maintenance cost of the asset during the agreement. Further, the time span of an operating lease is much lesser than a financing lease and ends sooner than the end of the economic life of the asset.
The characteristics of combination lease:
Combination leases are the customized leases containing mixed provisions of financial as well as operating lease. They are created to meet the different obligations of customers which neither of the two leases, operating and financing, can separately fulfil.
The characteristics of sale and leaseback are:
The owner of the equipment becomes the lessee as he sells the asset to another party and then lease back from him. Eventually, the original owner uses the asset without having ownership rights.

Explanation

The internal revenue service (IRS) has laid few guidelines regarding a lease agreement to classify it as a tax-oriented lease. A lease that fulfils all of these guidelines is considered as a tax-oriented lease,otherwise, it will be considered as a non-tax oriented lease.
The lessor will be entitled for the tax benefits if the IRS considered the lease as tax-oriented. However, a lessor will not be entitled for the tax benefits in case of a non-tax oriented lease.
The guidelines laid by IRS to consider a lease as tax oriented are:

The time period of a lease agreement should not exceed 80% of the total life of the asset leased or the remaining useful life of equipment left after the end of agreement should not be less than one year.
The estimated residual value of the asset left after the end of the agreement must not be less than 20% of the total value of equipment at the time of entering the agreement.
The lessee or any related party to the agreement must not hold the right to purchase the asset leased at a predetermined price.
The lessee or any related party to the contract should not have paid or guaranteed any payment on any part of equipment, that is, the lessee or the related party has not made any investment on the asset during the period of lease agreement.
The equipment must not be defined as a limited use property that is, it can not only be used by the lessee or any related party at the end of the lease term.

Verified Answer

Leases are classified into tax-oriented lease or non-tax oriented lease for tax purposes.
 
A lease that fulfils the guidelines issued by the Internal revenue service (IRS) regarding a lease agreement is a tax-oriented lease.
Whereas when a lease is not able to fulfil any of the guidelines of IRS, it will be considered as a non-tax oriented lease.
Under a tax oriented lease, the lessor is allowed to deduct the annual depreciation of the equipment leased and lessee is allowed to deduct the regular lease payments from the books.

Explanation

When a lease agreement exceeds a period of one year, the lease should be capitalised.
The assets and liabilities of the lease are considered as company’s liabilities and company’s assets. Hence, the reporting of leases in the books will increase the liabilities and assets of the company.
A lease liability is measured at the present value of the periodic lease payments and the lease assets, known as the right-of-use asset, are recorded as the asset value of the leased assets recorded in the books.

Verified Answer

When a lease term is more than one year,  the lease liability is reported as the company's liability and the corresponding lease asset is reported as the company's asset in the balance sheet. Therefore, the liabilities and assets of the company will increase with the reporting of leases in the balance sheet.

Explanation

A firm can lease an equipment in place of purchasing the equipment on loan. The lease and loan are substitutes of each other because both include the liability to pay regular payments in lieu of the equipment to its owner.
When the cost of leasing is less than the cost of owning the equipment, the firm approaches leasing over purchasing and thereby applying for lease decreases the borrowing capacity of the firm. So, to maintain the leverage, firms are forced to approach equity for further capital requirements.

Verified Answer

Leasing enhances the debt of the firm because leasing is considered as a replacement of loan.
So, when a firm has leased an equipment in place of purchasing it on loan, the lease would be treated as a debt on the firm and thus decreases the borrowing capacity of the firm, so in order to maintain the leverage, the company is forced to finance the remaining assets with equity.

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