Big Beta Securities Inc. has decided to acquire a new market data and quotation system for its Vancouver 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, Big Beta could obtain a term loan for the full purchase price at a 10% interest rate. The equipment falls into Class 45 with adeclining balance CCA rate of 45%. 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 $200,000. 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 Big Beta that Consolidated Leasing would be willing to write a 4-year lease on the equipment, including maintenance, for payments of $260,000 at the beginning of each year. Big Beta's tax rate is 35%. 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?
2. What are the five primary types of leases, and what are their characteristics?
3. What effect does leasing have on a firm's balance sheet?
4. What effect does leasing have on a firm's capital structure?
b. Explain the rationale for the discount rate you used to find the PV.
c. Calculate the net advantage to leasing (NAL). Does your analysis indicate that Big Beta should buy or lease the equipment? Explain.
d. Now assume that the equipment's residual value could be as low as $0 or as high as $400,000, but that $200,000 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 Big Beta's lease-versus-purchase decision?
e. 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?
f.
1. Assume that the lease payments were actually $280,000 per year, that Consolidated Leasing is also in the 35% tax bracket, and that it also forecasts a $200,000 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% pre-tax return on investments of similar risk. What would Consolidated's NPV of leasing be under these conditions?
2. What do you think the lessor's NPV would be if the lease payment were set at $260,000 per year?
g. Big Beta'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, Big Beta 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 Big Beta'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?