Martha Millon, financial manager for Fish & Chips Inc., has been asked to perform a lease-versus-buy analysis on a new computer system. The computer costs $1,200,000, and if it is purchased, Fish & Chips could obtain a term loan for the full amount at a 10% cost. The loan would be amortized over the 4-year life of the computer, with payments made at the end of each year. The computer is classified as special purpose; hence, it falls into the MACRS 3-year class. The applicable MACRS rates are 33%, 45%, 15%, and 7%. If the computer is purchased, a maintenance contract must be obtained at a cost of $25,000, payable at the beginning of each year.
After 4 years the computer will be sold. Millon’s best estimate of its residual value at that time is $125,000. Because technology is changing rapidly, however, the residual value is uncertain.
As an alternative, National Leasing is willing to write a 4-year lease on the computer, including maintenance, for payments of $340,000 at the beginning of each year. Fish & Chips’ marginal federal-plus-state tax rate is 40%. Help Millon conduct her analysis by answering the following questions.
a. (1) Why is leasing sometimes referred to as “off balance sheet” financing?
(2) What is the difference between a capital lease and an operating lease?
(3) What effect does leasing have on a firm’s capital structure?
b. (1) What is Fish & Chips’ present value cost of owning the computer? (Hint: Set up a table whose bottom line is a “time line” that shows the net cash flows over the period t = 0 to t = 4. Then find the PV of these net cash flows, or the PV cost of owning.)
(2) Explain the rationale for the discount rate you used to find the PV.
c. (1) What is Fish & Chips’ present value cost of leasing the computer? (Hint: Again, construct a time line.)
(2) What is the net advantage to leasing? Does your analysis indicate that the firm should buy or lease the computer? Explain.
d. Now assume that Millon believes the computer’s residual value could be as low as $0 or as high as $250,000, but she stands by $125,000 as her expected value. She concludes that the residual value is riskier than the other cash flows in the analysis, and she wants to incorporate this differential risk into her analysis. Describe how this can be accomplished. What effect will it have on the lease decision?
e. Millon knows that her firm has been considering moving its headquarters to a new location, and she is concerned that these plans may come to fruition prior to the expiration of the lease. If the move occurs, the company would obtain new computers; hence, Millon would like to include a cancellation clause in the lease contract. What effect would a cancellation clause have on the riskiness of the lease?