Autor: senouy 12 April 2012
Words: 7095 | Pages: 29
ANSWERS TO END-OF-CHAPTER QUESTIONS
20-1 a. The lessee is the party leasing the property. The party receiving the payments from the lease (that is, the owner of the property) is the lessor.
b. An operating lease, sometimes called a service lease, provides for both financing and maintenance. Generally, the operating lease contract is written for a period considerably shorter than the expected life of the leased equipment, and contains a cancellation clause. A financial lease does not provide for maintenance service, is not cancelable, and is fully amortized; that is, the lease covers the entire expected life of the equipment. In a sale and leaseback arrangement, the firm owning the property sells it to another firm, often a financial institution, while simulta¬neously entering into an agreement to lease the prop¬erty back from the firm. A sale and leaseback can be thought of as a type of financial lease. A combination lease combines some aspects of both operating and financial leases. For example, a financial lease which contains a cancellation clause--normally associated with operating leases--is a combination lease. In a leveraged lease, the lessor borrows a portion of the funds needed to buy the equipment to be leased.
c. Off-balance sheet financing refers to the fact that for many years neither leased assets nor the liabilities under lease contracts appeared on the lessees' balance sheets. To correct this problem, the Financial Accounting Standards Board issued FASB Statement 13. Capitalizing means incorporating the lease provisions into the balance sheet by reporting the leased asset under fixed assets and reporting the present value of future lease payments as debt.
d. FASB Statement 13 is the Financial Accounting Standards Board state¬ment (November 1976) that spells out in detail the conditions under which a lease must be capitalized, and the specific procedures to follow.
e. A guideline lease is a lease which meets all of the IRS requirements for a genuine lease. A guideline lease is often called a tax-oriented lease. If a lease meets the IRS guidelines, the IRS allows the lessor to deduct the asset's depreciation and allows the lessee to deduct the lease payments.
f. The residual value is the market value of the leased property at the expiration of the lease. The estimate of the residual value is one of the key elements in lease analysis.
g. The lessee's analysis involves determining whether leasing an asset is less costly than buying the asset. The lessee will compare the present value cost of leasing the asset with the present value cost of purchasing the asset (assuming the funds to purchase the asset are obtained through a loan). If the present value cost of the lease is less than the present value cost of purchasing, the asset should be leased. The lessee can also analyze the lease using the IRR approach. The IRR of the incremental cash flows of leasing versus purchasing represents the after-tax cost rate implied in the lease contract. If this rate is lower than the after-tax cost of debt, there is an advantage to leasing. Finally, the lessee might evaluate the lease using the equivalent loan method, which involves comparing the net savings at Time 0 if the asset is leased with the present value of the incremental costs of leasing over the term of the lease. If the Time 0 savings is greater than the present value of the incremental costs, there is an advantage to leasing.
The lessor's analysis involves determining the rate of return on the proposed lease. If the rate of return (or IRR) of the lease cash flows exceeds the lessor's opportunity cost of capital, the lease is a good investment. This is equivalent to analyzing whether the NPV of the lease is positive.
h. The net advantage to leasing (NAL) gives the dollar value of the lease to the lessee. It is, in a sense, the NPV of leasing versus owning.
i. The alternative minimum tax (AMT), which is figured at about 20 percent of the profits reported to stockholders, is a provision of the tax code that requires profitable firms to pay at least some taxes if such taxes are greater than the amount due under standard tax accounting. The AMT has provided a stimulus to leasing for those firms paying the AMT because leasing lowers profits reported to stockholders.
20-2 An operating lease is usually cancelable and includes mainten¬ance. Operating leases are, frequently, for a period signi¬ficantly shorter than the economic life of the asset, so the lessor often does not recover his full investment during the period of the basic lease. A financial lease, on the other hand, is fully amortized and generally does not include maintenance provisions. An operating lease would probably be used for a fleet of trucks, while a financial lease would be used for a manufacturing plant.
20-3 You would expect to find that lessees, in general, are in relatively low income-tax brackets, while lessors tend to be in high tax brackets. The reason for this is that owning tends to provide tax shelters in the early years of a proj¬ect's life. These tax shelters are more valuable to tax¬payers in high brackets. However, current tax laws (1998) have reduced the depreciation benefits of owning, so tax rate differentials are less important now than in the past.
20-4 The banks, when they initially went into leasing, were paying relatively high tax rates. However, since municipal bonds are tax exempt, their heavy investments in municipals lowered the banks' effective tax rates. Similarly, when the REIT loans began to sour, this further reduced the bank's income, and consequently cut the effective tax rate even further. Since the lease investments were predicated on obtaining tax shelters, and since the value of these tax shelters is dependent on the banks' tax rates, when the effective tax rates were lowered, this reduced the value of the tax shelters and consequently reduced the profitability of the lease investments.
20-5 a. Pros:
• The use of the leased premises or equipment is actually an exclusive right, and the payment for the premises is a liability that often must be met. Therefore, leases should be treated as both assets and liabilities.
• A fixed policy of capitalizing leases among all compan¬ies would add to the comparability of different firms. For example, Safeway Stores' leases should be capital¬ized to make the company comparable to A&P, which owns its stores through a subsidiary.
• The capitalization highlights the contractual nature of the leased property.
• Capitalizing of leases could help management make useful comparisons of operating results; that is, return on investment data.
• Because the firm does not actually own the leased property, the legal aspect can be cited as an argument against capitalization.
• Capitalizing leases worsens some key credit ratios; that is, the debt-to-equity ratio and the debt-to-total capital ratio. This may hamper the future acquisition of funds.
• There is a question of choosing the proper discount rate at which to capitalize the leases.
• Some argue that other items should be listed on the balance sheet before leases; for example, service con¬tracts, property taxes, and so on.
• Capitalizing leases violates the principle that liabil¬ities should be recorded only when assets are purchased.
20-6 Lease payments, like depreciation, are deductible for tax purposes. If a 20-year asset were depreciated over a 20-year life, depreciation charges would be 1/20 per year (more if MACRS were used). However, if the asset were leased for, say, 3 years, tax deductions would be 1/3 each year for 3 years. Thus, the tax deductions would be greatly acceler¬ated. The same total taxes would be paid over the 20 years, but because of the high deductions in the early years, taxes would be deferred more under the lease, and the PV of the future taxes would be reduced under the lease.
20-7 In fact, Congress did this in 1981. Depreciable lives were shorter than before; corporate tax rates were essentially un¬changed (they were lowered very slightly on income below $50,000); and the investment tax credit had been improved a bit by the easing of recapture if the asset was held for a short period. As a result, companies that were either inves¬ting at a very high rate or else were only marginally profitable were generating more depreciation and/or investment tax credits than they could use. These companies were able to "sell" their tax shelters through a leasing arrangement, being "paid" in the form of lower lease charges. A high-bracket lessor could earn a given after-tax return with lower rental charges, after the 1981 tax law changes, than previously because the lessor would get (1) the larger tax credits and (2) faster depreciation write-offs.
20-8 A cancellation clause would reduce the risk to the lessee since the firm would be allowed to terminate the lease at any point. Since the lease is less risky than a standard financial lease, and less risky than straight debt, which cannot usually be prepaid without a prepayment charge, the discount rate on the cost of leasing might be adjusted to reflect lower risk. (Note that this requires increasing the discount rate since cash outflows are being discounted.) The effect on the lessor is just the opposite--risk is increased. (Note that this would also require an increase in the lessor's discount rate.)
SOLUTIONS TO END-OF-CHAPTER PROBLEMS
20-1 a. (1) Reynolds' current debt ratio is $400/$800 = 50%.
(2) If the company purchased the equipment its balance sheet would look like:
Current assets $300 Debt (including lease) $600
Fixed assets 500
Leased equipment 200 Equity $400
Total assets $1,000 Total claims $1,000
Therefore, the company's debt ratio = $600/$1,000 = 60%.
(3) If the company leases the asset and does not capitalize the lease, its debt ratio = $400/$800 = 50%.
b. The company's financial risk (assuming the implied interest rate on the lease is equivalent to the loan) is no different whether the equipment is leased or purchased.
20-2 Cost of owning:
0 1 2
| | |
Depreciation shield 40 40
(200) 40 40
PV at 6% = -$127.
Cost of leasing:
0 1 2
| | |
After-tax lease payment (66) (66)
PV at 6% = -$128.
Reynolds should buy the equipment, because the cost of owning is less than the cost of leasing.
0 1 2 3 4____
I. Cost of Owning:
Net purchase price ($1,500,000)
Depr. tax savingsa $198,000 $270,000 $ 90,000 $ 42,000
Net cash flow ($1,500,000) $198,000 $270,000 $ 90,000 $ 42,000
PV cost of owning at 9% ($ 991,845)
II. Cost of Leasing:
Lease payment (AT) (240,000) (240,000) (240,000) (240,000)
Purch. option priceb (250,000)
Net cash flow $ 0 ($240,000) ($240,000) ($240,000) ($490,000)
PV cost of leasing at 9% ($ 954,639)
III. Cost Comparison
Net advantage to leasing (NAL) = PV cost of owning - PV cost of leasing
= $991,845 - $954,639
aCost of new machinery: $1,500,000.
MACRS Deprec. Tax Savings
Year Allowance Factor Depreciation T (Depreciation)
1 0.33 $495,000 $198,000
2 0.45 675,000 270,000
3 0.15 225,000 90,000
4 0.07 105,000 42,000
bCost of purchasing the machinery after the lease expires.
Note that the maintenance expense is excluded from the analysis since Big Sky Mining will have to bear the cost whether it buys or leases the machinery. Since the cost of leasing the machinery is less than the cost of owning it, Big Sky Mining should lease the equipment.
20-4 a. Balance sheets before lease is capitalized:
(Thousands of Dollars)
Total assets $200 Total claims $200
Debt/assets ratio = $100/$200 = 50%.
(Thousands of Dollars)
Debt $ 50
Total assets $150 Total claims $150
Debt/assets ratio = $50/$150 = 33%.
b. Balance sheet after lease is capitalized:
(Thousands of Dollars)
Assets $150 Debt $ 50
Value of leased asset 50 PV of lease payments 50
Total assets $200 Total claims $200
Debt/assets ratio = $100/$200 = 50%.
c. Yes. Net income, as reported, would probably be less under leasing because the lease payment would be larger than the interest expense, both of which are income statement expenses. Additionally, total assets are significantly less under leasing without capitalization.
The net result is difficult to predict, but we can state positively that both ROA and ROE are affected by the choice of financing.
20-5 a. Borrow and buy analysis:
Year 0 Year 1 Year 2 Year 3
Loan payments (430,731) (430,731) (430,731)
Interest tax savings 47,600 33,761 17,985
Depreciation tax savings 112,200 153,000 51,000
Net cash flow $ 0 $270,931 $243,970 $361,746
PV cost of owning @ 9.24%a = ($729,956)
Year Allowance Depreciation
1 0.33 $330,000
2 0.45 450,000
3 0.15 150,000
Loan Amortization Schedule
Beginning of Remaining
Year Amount Payment Interest Principal Balance
1 $1,000,000 $430,731 $140,000 $290,731 $709,269
2 709,269 430,731 99,298 331,433 $377,836
3 377,836 430,731 52,897 377,834 2*
*Difference due to rounding.
Year 0 Year 1 Year 2 Year 3
Lease payment ($320,000) ($320,000) ($320,000)
Payment tax savings 108,800 108,800 108,800
Mkt Value Machine ( 200,000)c
Net cash flow $ 0 ($211,200) ($211,200) ($411,200)
PV cost of leasing @ 9.24% = ($685,752)
aDiscount rate = 14% x (1 - T) = 14% x (1 - 0.34) = 9.24%.
bDepreciable basis = Cost = $1,000,000. MACRS allowances = 33%, 45%, 15%. Depreciation tax savings = T(Depreciation).
cCost of purchasing the machinery after the lease expires. Note that since the firm is purchasing the machine at the end of the lease, there are no tax effects due to the residual value (purchase price) being greater than the book value. If we were to assume that the firm would not want to keep the machine beyond the lease term, then we would show the residual value of selling the machine as an inflow under the purchase alternative, and there would be no residual value flow under the lease alternative. In that situation, there would be tax on the residual value from selling the machine: ($200,000 - $70,000)0.34 = $44,200.
Note that the maintenance expense is excluded from the analysis since the firm will have to bear the cost whether it buys or leases the machinery. Since the cost of leasing the machinery is less than the cost of owning it ($729,956 - $685,752 = $44,204), the firm should lease the equipment.
b. We assume that the company will buy the equipment at the end of 3 years if the lease plan is used; hence, the $200,000 is an added cost under leasing. We discounted it at 9.24 percent, but it is risky, so should we use a higher rate? If we do, leasing looks even better. How¬ever, it really makes more sense in this instance to use a lower rate to discount the residual value so as to penalize the lease decision, because the residual value uncertainty increases the uncertainty of operations under the lease alternative. In general, for risk-averse decision makers, it makes intuitive sense to discount more risky future inflows at a higher rate, but risky future outflows at a lower rate. (Note that if the firm did not plan to continue using the equipment, then the $200,000 salvage value should be a negative (inflow) value in the lease analysis. In that case, it would be appropriate to use a higher discount rate.)
SOLUTION TO SPREADSHEET PROBLEMS
20-6 The detailed solution for the problem is available both on the instructor's resource CD-ROM (in the file Solution for Ch 20-6 Build a Model.xls) and on the instructor's side of the Harcourt College Publishers' web site, http://www.harcourtcollege.com/finance/theory10e.
20-7 a. Depreciation Schedule
Year Allowance Depreciation
1 0.33 $13,200
2 0.45 18,000
3 0.15 6,000
4 0.07 2,800
0 1 2 3 4
| | | | |
Net cost ($40,000)
Lease (AT) 6,900 $ 6,900 $ 6,900 $ 6,900
Maintenance (AT) (600) (600) (600) (600)
Depreciation shield 5,280 7,200 2,400 $ 1,120
SV tax* (4,000)
Net CF ($33,700) $11,580 $13,500 $ 8,700 $ 7,120
*(SV - BV)T = ($10,000 - $0)(0.40) = $4,000.
The NPV of the net cash flows, when discounted at 9%(1 - 0.40) = 5.4%, is $2,638.
b. Yes. The positive NPV indicates that the lease will provide a return greater than that provided by alter¬native investments of similar risk.
c. The NPV to the lessor falls to -$353 at an after-tax discount rate of 16%(0.6) = 9.6%. This negative NPV leads to a reject decision.
d. A lease payment of $11,668 would cause the lessor to be indifferent to the leasing arrangement at a 16 percent before-tax lending rate.
e. Best case NPV: $5,069 with $15,000 residual value. Worst case NPV: $207 with $5,000 residual value.
A residual discount factor of 38 percent (before-tax) forces the
NPV to equal zero.
20-8 The detailed solution for the cyberproblem is available on the instructor's side of the Harcourt College Publishers' web site: http://www.harcourtcollege.com/finance/theory10e.
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 ON-LINE DATA SERVICES, 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 PERCENT INTEREST RATE. THE EQUIPMENT IS CLASSIFIED AS A SPECIAL-PURPOSE COMPUTER, SO IT 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 AT THAT TIME IS $100,000. HOWEVER, SINCE 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 $280,000 AT THE BEGINNING OF EACH YEAR. LEWIS'S MARGINAL FEDERAL-PLUS-STATE TAX RATE IS 40 PERCENT. 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?
ANSWER: THE TWO PARTIES ARE THE LESSEE, WHO USES THE ASSET, AND THE LESSOR, WHO OWNS THE ASSET.
A. 2. WHAT ARE THE FOUR PRIMARY TYPES OF LEASES, AND WHAT ARE THEIR CHARACTERISTICS?
ANSWER: THE FOUR PRIMARY TYPES OF LEASES ARE OPERATING, FINANCIAL, SALE AND LEASEBACK, AND CONTRIBUTION. AN OPERATING LEASE, SOMETIMES CALLED A SERVICE LEASE, PROVIDES FOR BOTH FINANCING AND MAINTENANCE. GENERALLY, THE OPERATING LEASE CONTRACT IS WRITTEN FOR A PERIOD CONSIDERABLY SHORTER THAN THE EXPECTED LIFE OF THE LEASED EQUIPMENT, AND CONTAINS A CANCELLATION CLAUSE. A FINANCIAL LEASE DOES NOT PROVIDE FOR MAINTENANCE SERVICE, IS NOT CANCELABLE, AND IS FULLY AMORTIZED; THAT IS, THE LEASE COVERS THE ENTIRE EXPECTED LIFE OF THE EQUIPMENT. IN A SALE AND LEASEBACK ARRANGEMENT, THE FIRM OWNING THE PROPERTY SELLS IT TO ANOTHER FIRM, OFTEN A FINANCIAL INSTITUTION, WHILE SIMULTA¬NEOUSLY ENTERING INTO AN AGREEMENT TO LEASE THE PROP¬ERTY BACK FROM THE FIRM. A SALE AND LEASEBACK CAN BE THOUGHT OF AS A TYPE OF FINANCIAL LEASE.
A COMBINATION LEASE COMBINES SOME ASPECTS OF BOTH OPERATING AND FINANCIAL LEASES. FOR EXAMPLE, A FINANCIAL LEASE WHICH CONTAINS A CANCELLATION CLAUSE--NORMALLY ASSOCIATED WITH OPERATING LEASES--IS A COMBINATION LEASE. IN A LEVERAGED LEASE, THE LESSOR BORROWS A PORTION OF THE FUNDS NEEDED TO BUY THE EQUIPMENT TO BE LEASED.
A. 3. HOW ARE LEASES CLASSIFIED FOR TAX PURPOSES?
ANSWER: A GUIDELINE LEASE IS A LEASE WHICH MEETS ALL OF THE IRS REQUIREMENTS FOR A GENUINE LEASE. A GUIDELINE LEASE IS OFTEN CALLED A TAX-ORIENTED LEASE. IF A LEASE MEETS THE IRS GUIDELINES, THE IRS ALLOWS THE LESSOR TO DEDUCT THE ASSET'S DEPRECIATION AND ALLOWS THE LESSEE TO DEDUCT THE LEASE PAYMENTS.
A. 4. WHAT EFFECT DOES LEASING HAVE ON A FIRM'S BALANCE SHEET?
ANSWER: IF THE LEASE IS CLASSIFIED AS A CAPITAL LEASE, IT IS SHOWN DIRECTLY ON THE BALANCE SHEET. IF IT IS AN OPERATING LEASE, IT IS ONLY LISTED IN THE FOOTNOTES.
A. 5. WHAT EFFECT DOES LEASING HAVE ON A FIRM'S CAPITAL STRUCTURE?
ANSWER: LEASING IS A SUBSTITUTE FOR DEBT FINANCING, SO LEASING INCREASES A FIRM'S FINANCIAL LEVERAGE.
B. 1. WHAT IS THE PRESENT VALUE COST OF OWNING THE EQUIPMENT? (HINT: SET UP A TIME LINE WHICH SHOWS THE NET CASH FLOWS OVER THE PERIOD t = 0 TO t = 4, AND THEN FIND THE PV OF THESE NET CASH FLOWS, OR THE PV COST OF OWNING.)
ANSWER: TO DEVELOP THE COST OF OWNING, WE BEGIN BY CONSTRUCTING THE DEPRECIATION SCHEDULE: DEPRECIABLE BASIS = $1,000,000.
MACRS DEPRECIATION END-OF-YEAR
YEAR RATE EXPENSE BOOK VALUE
1 0.33 $ 330,000 $670,000
2 0.45 450,000 220,000
3 0.15 150,000 70,000
4 0.07 70,000 0
COST OF OWNING TIME LINE:
0 1 2 3 4
| | | | |
AT LOAN PAYMENT -60,000 -60,000 -60,000 -1,060,000
DEP. TAX SAVINGS1 132,000 180,000 60,000 28,000
MAINTENANCE (AT)2 -12,000 -12,000 -12,000 -12,000
RES. VALUE (AT)3 _______ _______ _______ _______ 60,000
NET CASH FLOW -12,000 60,000 108,000 -12,000 -972,000
1DEPRECIATION IS A TAX-DEDUCTIBLE EXPENSE, SO IT PRODUCES A TAX SAVINGS OF T(DEPRECIATION). FOR EXAMPLE, THE SAVINGS IN YEAR 1 IS 0.4($330,000) = $132,000.
2EACH MAINTENANCE EXPENSE IS $20,000, BUT IT IS TAX DEDUCTIBLE, SO THE AFTER-TAX FLOW IS (1 - T)$20,000 = $12,000.
3THE ENDING BOOK VALUE IS $0, SO TAXES MUST BE PAID ON THE FULL $100,000 SALVAGE (RESIDUAL) VALUE.
PV COST OF OWNING (@6%) = $639,267.
B. 2. EXPLAIN THE RATIONALE FOR THE DISCOUNT RATE YOU USED TO FIND THE PV.
ANSWER: THE PROPER DISCOUNT RATE DEPENDS ON (1) THE RISKINESS OF THE CASH FLOW STREAM AND (2) THE GENERAL LEVEL OF INTEREST RATES. THE LOAN PAYMENTS AND THE MAINTENANCE COSTS ARE FIXED BY CONTRACT, HENCE ARE NOT AT ALL RISKY. THE DEPRECIATION DEDUCTIONS ARE ALSO "LOCKED IN," BUT THE TAX RATE COULD CHANGE. THUS, DEPRECIATION CASH FLOWS (TAX SAVINGS) ARE NOT TOTALLY CERTAIN, BUT THEY ARE RELATIVELY CERTAIN. ONLY THE RESIDUAL VALUE IS HIGHLY UNCERTAIN. ON BALANCE, AND IN RELATION TO CASH FLOWS ASSOCIATED WITH SUCH ACTIVITIES AS CAPITAL BUDGETING, WE CONCLUDE THAT THE CASH FLOWS IN THE TIME LINE ARE RELATIVELY SAFE, SO THEY SHOULD BE DISCOUNTED AT A RELATIVELY LOW RATE. IN FACT, THEY HAVE ABOUT THE SAME DEGREE OF RISKINESS AS THE FIRM'S DEBT CASH FLOWS (WHICH ALSO HAVE SOME TAX RATE RISK, AND WHICH ARE ALSO CONTRACTUAL IN NATURE). THEREFORE, WE CONCLUDE THAT LEASING HAS ABOUT THE SAME IMPACT ON THE FIRM'S FINANCIAL RISK AS DEBT FINANCING, SO THE APPROPRIATE DISCOUNT RATE IS LEWIS'S COST OF DEBT. (NOTE: THE LARGER THE RESIDUAL VALUE IN RELATION TO THE OTHER FLOWS, THE LESS JUSTIFIABLE IS THIS STATEMENT.) FURTHER, SINCE THE CASH FLOWS ARE STATED ON AN AFTER-TAX BASIS, THE RATE SHOULD BE THE AFTER-TAX COST OF DEBT. LEWIS'S BEFORE-TAX DEBT COST IS 10 PERCENT, AND SINCE THE FIRM IS IN THE 40 PERCENT TAX BRACKET, ITS AFTER-TAX COST IS 10.0%(1 - 0.40) = 6.0%. THEREFORE, WE USE 6 PERCENT AS THE DISCOUNT RATE.
NOTE: WHEN WE HAVE BEEN ENGAGED AS CONSULTANTS ON LEASE-VERSUS-BUY DECISIONS, THE PROPER DISCOUNT RATE IS OFTEN DISCUSSED. WE KNOW OF NO WAY TO SPECIFY EXACTLY HOW TO ADJUST FOR THE SALVAGE (RESIDUAL) VALUE RISK. THEREFORE, WHAT WE HAVE BEEN DOING IS RUNNING THE ANALYSIS ON A SPREADSHEET MODEL AND MAKING A DATA TABLE WHERE THE DEPENDENT VARIABLE IS THE NAL AS CALCULATED BELOW AND THE INDEPENDENT VARIABLE IS THE DISCOUNT RATE. THEN, WE PRODUCE A GRAPH WHICH SHOWS THE RANGE OF DISCOUNT RATES OVER WHICH THE NAL IS POSITIVE. THIS USUALLY HEADS OFF PROBLEMS OVER THE PROPER DISCOUNT RATE.
C. WHAT IS LEWIS'S PRESENT VALUE COST OF LEASING THE EQUIPMENT? (HINT: AGAIN, CONSTRUCT A TIME LINE.)
ANSWER: IF LEWIS LEASED THE EQUIPMENT, ITS ONLY CASH FLOWS WOULD BE THE AFTER-TAX LEASE PAYMENTS:
0 1 2 3 4
| | | | |
LEASE PMT. (AT)1 -168,000 -168,000 -168,000 -168,000
1EACH LEASE PAYMENT IS $280,000, BUT THIS IS DEDUCTIBLE, SO THE AFTER-TAX COST OF THE LEASE IS (1 - T)($280,000) = $168,000.
PV COST OF LEASING (@6%) = $617,066.
D. WHAT IS THE NET ADVANTAGE TO LEASING (NAL)? DOES YOUR ANALYSIS INDICATE THAT LEWIS SHOULD BUY OR LEASE THE EQUIPMENT? EXPLAIN.
ANSWER: THE NET ADVANTAGE TO LEASING (NAL) IS $22,201:
NAL = PV COST OF OWNING - PV COST OF LEASING
= $639,267 - $617,066 = $22,201.
THE NAL IS POSITIVE, WHICH INDICATES THAT THE PV COST OF OWNING IS GREATER. THEREFORE, LEASING IS LESS EXPENSIVE THAN BORROWING AND BUYING, SO LEWIS SHOULD LEASE THE EQUIPMENT RATHER THAN PURCHASE IT.
E. NOW ASSUME THAT THE EQUIPMENT'S RESIDUAL VALUE COULD BE AS LOW AS $0 OR AS HIGH AS $200,000, BUT THAT $100,000 IS THE EXPECTED VALUE. SINCE THE RESIDUAL VALUE IS RISKIER THAN THE OTHER CASH FLOWS IN THE ANALYSIS, 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 INCREASED UNCERTAINTY ABOUT THE RESIDUAL VALUE HAVE ON LEWIS'S LEASE-VERSUS-PURCHASE DECISION?
ANSWER: FIRST, NOTE THAT THE RESIDUAL VALUE IN A LEASE ANALYSIS WILL BE SHOWN EITHER IN THE "COST OF OWNING SECTION" OR IN THE "COST OF LEASING" SECTION, DEPENDING ON WHETHER OR NOT THE COMPANY PLANS TO CONTINUE USING THE LEASED ASSET AT THE EXPIRATION OF THE BASIC LEASE. IF THE LESSEE PLANS TO CONTINUE USING THE EQUIPMENT, THEN IT WILL HAVE TO BE PURCHASED WHEN THE LEASE EXPIRES, AND IN THIS CASE THE RESIDUAL VALUE APPEARS AS A COST IN THE LEASING COST SECTION. HOWEVER, IF THE LESSEE PLANS NOT TO CONTINUE USING THE EQUIPMENT, THEN THE RESIDUAL VALUE WILL NOT BE SHOWN IN THE LEASING SECTION--RATHER, IT WILL BE SHOWN AS AN INFLOW IN THE COST OF OWNING SECTION. IN LEWIS'S CASE, THE ASSET WILL NOT BE NEEDED AT THE EXPIRATION OF THE LEASE, SO THE RESIDUAL IS SHOWN AS AN INFLOW IN THE OWNING SECTION. IN THIS SITUATION, WE ACCOUNT FOR INCREASED RISK BY INCREASING THE RATE USED TO DISCOUNT THE RESIDUAL VALUE CASH FLOW, RESULTING IN A LOWER PRESENT VALUE OF THE RESIDUAL CASH FLOW. THIS LEADS TO A HIGHER COST OF OWNING, SO THE GREATER THE RISK OF THE RESIDUAL VALUE, THE HIGHER THE COST OF OWNING, AND THE MORE ATTRACTIVE LEASING BECOMES.
NOTE, THOUGH, THAT THE SITUATION WOULD BE DIFFERENT IF LEWIS PLANNED TO LEASE AND THEN EXERCISE A FAIR MARKET VALUE PURCHASE OPTION IN ORDER TO CONTINUE USING THE EQUIPMENT. THEN THE RESIDUAL WOULD BE SHOWN AS A COST IN THE LEASING SECTION, AND ITS HIGHER RISK WOULD BE REFLECTED BY DISCOUNTING IT AT A LOWER RATE. IN THAT SITUATION THE RISKINESS OF THE RESIDUAL WOULD PENALIZE RATHER THAN HELP THE LEASE.
IN THE CASE AT HAND, THE LESSOR, NOT THE LESSEE, WILL OWN THE ASSET AT THE END OF THE LEASE, SO THE LESSOR BEARS THE RESIDUAL VALUE RISK. IN EFFECT, THE LEASE TRANSACTION PASSES THE RISK ASSOCIATED WITH THE RESIDUAL VALUE FROM THE LESSEE/USER TO THE LESSOR. OF COURSE, THE LESSOR RECOGNIZES THIS, AND AS A RESULT, ASSETS WITH HIGHLY UNCERTAIN RESIDUAL VALUES WILL CARRY HIGHER LEASE PAYMENTS THAN ASSETS WITH RELATIVELY CERTAIN RESIDUAL VALUES. HOWEVER, THE MOST SUCCESSFUL LEASING COMPANIES HAVE DEVELOPED EXPERTISE IN RENOVATING AND DISPOSING OF USED EQUIPMENT, AND THIS GIVES THEM AN ADVANTAGE OVER MOST LESSEES IN REDUCING RESIDUAL VALUE RISKS. FURTHER, LEASING COMPANIES USUALLY DEAL WITH A WIDE ARRAY OF ASSETS, SO RESIDUAL VALUE ESTIMATES THAT ARE TOO HIGH ON ONE ASSET MAY BE OFFSET BY ESTIMATES THAT ARE TOO LOW ON ANOTHER.
F. THE LESSEE COMPARES THE COST OF OWNING THE EQUIPMENT WITH THE COST 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 WRITE THE LEASE?
ANSWER: THE LESSOR SHOULD VIEW "WRITING" THE LEASE AS AN INVESTMENT, SO THE LESSOR SHOULD COMPARE THE RETURN ON THE LEASE WITH RETURNS AVAILABLE ON ALTERNATIVE INVESTMENTS OF SIMILAR RISK.
G. 1. ASSUME THAT THE LEASE PAYMENTS WERE ACTUALLY $300,000 PER YEAR, THAT CONSOLIDATED LEASING IS ALSO IN THE 40 PERCENT TAX BRACKET, AND THAT IT ALSO FORECASTS A $100,000 RESIDUAL VALUE. ALSO, TO FURNISH THE MAINTENANCE SUPPORT, CONSOLIDATED WOULD HAVE TO PURCHASE A MAINTENANCE CONTRACT FROM THE MANUFACTURER AT THE SAME $20,000 ANNUAL COST, AGAIN PAID IN ADVANCE. CONSOLIDATED LEASING CAN OBTAIN AN EXPECTED 10 PERCENT PRE-TAX RETURN ON INVESTMENTS OF SIMILAR RISK. WHAT WOULD CONSOLIDATED'S NPV AND IRR OF LEASING BE UNDER THESE CONDITIONS?
ANSWER: THE LESSOR MUST INVEST $1,000,000 TO BUY THE EQUIPMENT, BUT THEN IT EXPECTS TO RECEIVE TAX BENEFITS AND LEASE PAYMENTS OVER THE LIFE OF THE LEASE. NOTE THAT THE DEPRECIATION EXPENSES CALCULATED EARLIER ALSO APPLY TO THE LESSOR, SO WE HAVE THIS CASH FLOW STREAM:
0 1 2 3 4
| | | | |
COST OF ASSET -1,000,000
DEP. TAX SAVINGS 132,000 180,000 60,000 28,000
MAINTENANCE (AT) -12,000 -12,000 -12,000 -12,000
LEASE PMT.(AT) 180,000 180,000 180,000 180,000
RES. VALUE (AT) __________ _______ _______ _______ 60,000
NET CASH FLOW -832,000 300,000 348,000 228,000 88,000
NPV @ 6% = $21,875.
IRR = 7.35%.
MIRR = 6.69% using k = 6%.
G. 2. WHAT DO YOU THINK THE LESSOR'S NPV WOULD BE IF THE LEASE PAYMENT WERE SET AT $280,000 PER YEAR? (HINT: THE LESSOR'S CASH FLOWS WOULD BE A "MIRROR IMAGE" OF THE LESSEE'S CASH FLOWS.)
ANSWER: WITH LEASE PAYMENTS OF $280,000, THE LESSOR'S CASH FLOWS WOULD BE THE "MIRROR IMAGE" OF THE LESSEE'S NAL--THE SAME DOLLARS, BUT WITH SIGNS REVERSED. THEREFORE, THE LESSOR'S NPV WOULD BE -$22,201, THE NEGATIVE OF THE LESSEE'S NAL. TO VERIFY THIS, NOTE THAT A $20,000 REDUCTION IN EACH LEASE PAYMENT WOULD REDUCE THE LESSOR'S INFLOWS BY $20,000(0.6) = $12,000 AT THE BEGINNING OF EACH YEAR. THE PV OF THIS ANNUITY IS $44,076, SO THE LESSOR'S NPV WOULD BE $21,875 - $44,076 = -$22,201.
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 EXPIRATION OF THE LEASE. IF THE MOVE OCCURS, LEWIS WOULD BUY OR LEASE AN ENTIRELY NEW SET OF EQUIPMENT, AND HENCE MANAGEMENT WOULD LIKE TO INCLUDE A CANCELLATION CLAUSE IN THE LEASE CONTRACT. WHAT IMPACT 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 LEASE TERMS IF A CANCELLATION CLAUSE WERE ADDED? SHOULD THE CANCELLATION CLAUSE CONTAIN ANY RESTRICTIVE COVENANTS AND/OR PENALTIES OF THE TYPE CONTAINED IN BOND INDENTURES OR PROVISIONS SIMILAR TO CALL PREMIUMS?
ANSWER: A CANCELLATION CLAUSE WOULD LOWER THE RISK OF THE LEASE TO LEWIS, THE LESSEE, BECAUSE THEN IT WOULD NOT BE OBLIGATED TO MAKE THE LEASE PAYMENTS FOR THE ENTIRE TERM OF THE LEASE. IF ITS SITUATION CHANGED, SO THAT LEWIS EITHER NO LONGER NEEDED THE EQUIPMENT OR ELSE WANTED TO CHANGE TO A MORE TECHNOLOGICALLY ADVANCED PRODUCT, THEN IT COULD TERMINATE THE LEASE.
HOWEVER, A CANCELLATION CLAUSE WOULD MAKE THE CONTRACT MORE RISKY FOR THE LESSOR. NOW THE LESSOR BEARS NOT ONLY THE FINAL RESIDUAL VALUE RISK, BUT ALSO THE UNCERTAINTY OF WHEN THE CONTRACT WILL BE TERMINATED.
TO ACCOUNT FOR THE ADDITIONAL RISK, THE LESSOR WOULD UNDOUBTEDLY INCREASE THE ANNUAL LEASE PAYMENT. ADDITIONALLY, THE LESSOR MIGHT INCLUDE CLAUSES THAT WOULD PROHIBIT CANCELLATION FOR SOME PERIOD AND/OR IMPOSE A PENALTY FEE FOR EARLY CANCELLATION. THE DECISION AS TO WHETHER OR NOT TO INCLUDE A CANCELLATION CLAUSE WOULD DEPEND ON WHO WAS IN A BETTER POSITION TO BEAR THE RESIDUAL VALUE RISK, THE LESSEE OR THE LESSOR. OFTEN LESSORS HAVE MORE EXPERTISE AT DISPOSING OF USED EQUIPMENT THAN LESSEES, AND THUS THEY ARE WILLING TO INCLUDE CANCELLATION CLAUSES WITHOUT MAJOR INCREASES IN THE REQUIRED LEASE PAYMENTS.