Lease-Versus-Purchase Decision: Analyzing Equipment Acquisition for Lewis Securities Inc.

Questions:

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

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

3. How are leases classified for tax purposes?

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

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

6. What is the present value of owning the equipment? What is the discount rate for the cash flows of owning?

7. What is Lewis’s present value of leasing the equipment? What is the net advantage to leasing (NAL)? Does your analysis indicate that Lewis should buy or lease the equipment?

8. Describe how the differential risk of the residual value could be incorporated into the analysis. What effect would the increased uncertainty of the residual value have on Lewis’s lease-versus-purchase decision?

9. How should the lessor analyze the decision to write or not to write the lease?

Answers:

(1) The two parties to a lease transaction are the lessor (the owner of the asset) and the lessee (the party leasing the asset).

(2) The four primary types of leases are:

a. Operating lease: In an operating lease, the lessor retains ownership of the asset, and the lessee uses the asset for a specific period. It is usually a short-term lease and does not transfer the risks and rewards of ownership to the lessee.

b. Financial lease: In a financial lease, the lessor transfers most of the risks and rewards of ownership to the lessee. The lessee is responsible for maintenance, insurance, and other costs associated with the leased asset. At the end of the lease term, the lessee may have the option to purchase the asset at a predetermined price.

c. Sale and leaseback: A sale and leaseback arrangement involves the sale of an asset by the owner (lessee) to a third party (lessor) and then leasing the asset back from the lessor.

d. Direct financing lease: In a direct financing lease, the lessor provides financing for the acquisition of an asset by the lessee. The lessor does not retain any residual interest in the asset and only earns interest income from the lease payments.

(3) Leases are classified for tax purposes as either operating leases or capital leases.

(4) Leasing increases both assets and liabilities on a firm's balance sheet.

(5) Leasing increases a firm's leverage ratio, affecting its capital structure.

Analysis:

In analyzing the lease-versus-purchase decision for Lewis Securities Inc., it is essential to consider the various factors involved in equipment acquisition and financing. The choice between leasing and buying can have significant implications for the firm's financial position and cash flows.

1. When calculating the present value of owning the equipment, it is important to account for the net cash flows over the period of use, including the purchase price, maintenance costs, and the estimated residual value. The discounted cash flows should be evaluated using the appropriate discount rate, which in this case is the weighted average cost of capital (WACC) at 14%.

2. The present value of leasing the equipment involves discounting the lease payments back to their present value using the relevant discount rate. The net advantage to leasing (NAL) is determined by comparing the present value of owning with the present value of leasing. A positive NAL indicates that leasing is more advantageous, while a negative NAL suggests that owning is more beneficial.

3. The differential risk of the residual value can be addressed by incorporating a risk-adjusted approach to the analysis. This involves assigning probabilities to different outcomes of the residual value and adjusting the cash flows accordingly. The uncertainty surrounding the residual value can impact the lease-versus-purchase decision, especially if the range of possible outcomes widens or the likelihood of a lower residual value increases.

4. From the lessor's perspective, the decision to write or not to write the lease should be evaluated based on the financial implications, risk considerations, and strategic objectives. The lessor should assess the potential benefits and risks associated with the lease arrangement, considering factors such as cash flow generation, asset utilization, and residual value expectations.

In conclusion, the lease-versus-purchase decision for Lewis Securities Inc. requires a comprehensive analysis of the equipment acquisition options, financing alternatives, and risk factors. By assessing the implications of leasing versus buying, the firm can make an informed decision that aligns with its financial goals and operational requirements.