Answer

C

ANSWER

Lease vs. Purchase and Tactical Financial Decisions

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

The two parties are the lessor, who possesses the asset, and the lessee, who makes use of the asset.

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

The five types of leases are financial, sale and leaseback, operating, synthetic, and combination. A financial lease is fully amortized, in not cancelable, and provides no room for maintenance service (Benamraoui et al., 2017). Operating lease (also known as service lease) offers for both maintenance and financing. The operating lease agreement is generally written for a span of time that is considerably shorter than the predicted life of a leased equipment, and has a cancellation clause (Ghiami & Beullens, 2016). A synthetic lease arises when an organization creates a special purpose entity (SPE) that borrows and thereafter buys an asset (often a long term asset) and leases it back to the organization (Weng, 2016). The organization warrants the SPE’s debt and enters an operating lease with it. Usually, this arrangement is employed in avoiding capitalizing the lease, and thus, reporting it as a company’s liability. Notwithstanding the fact that the company has a liability, it does not report the liability. Owing to the act that the lease is an operating one, it does not capitalize it and report the lease the asset as an asset and payment as a liability (Ghiami & Beullens, 2016). As such, tractions may leave no proof on a company’s balance sheet except in the footnotes. A sale and leaseback system is an arrangement where a company owning a property sells the same to another company, usually a financial institution, while at the same time entering an agreement to lease the property back from the company (Benamraoui et al., 2017). A combination lease amalgamates some facets of the financial and operating leases (Weng, 2016). For instance, a financial lease that contains a cancellation clause, usually linked with operating lease, is a combination lease.

(3) How are leases classified for tax purposes?

A guideline lease (also known as a tax-oriented lease), according to Benamraoui et al. (2017), is a lease that attains all the Internal Revenue Service (IRS) requirements for a genuine lease. If a lease meets the guidelines of IRS, IRS allows the lessor to subtract the asset’s depreciation and permits the lessee to subtract the lease payments.

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

If a lease is categorized as a capital one, it is directly shown on a firm’s balance sheet. However, if the lease is an operating one, it may only be listed in a company’s balance sheet’s footnotes (Ghiami & Beullens, 2016).

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

Leasing increases a company’s financial leverage since it is a substitute for debt financing.

(1) What is the present value of owning the equipment?

To compute the equipment’s present value (PV) cost of owning, we start by depreciation value:

The depreciable basis = 1,000,000

Cost Of Owning Time Line

^a Depreciation is a tax-deductible expense. Thus, it yields a tax savings of federal-plus-state tax rate (t) x depreciation. For instance, the first year’s savings is 0.25($330,000) = $82,500.

^b Each year’s maintenance expense is $20,000. However, it is tax-deductible. Thus, the after-tax flow is (1 – t) x $20,000 = $15,000

^c  The ending book value is $0. Therefore, taxes must be paid on the full $200,000 salvage value (residual value). That is, (1 – t) x $200,000 = $150,000

PV costing of owning the equipment  at 6% = $591,741

(2) What is the discount rate for the cash flows of owning?

To determine the discount rate, we multiply the company’s 10% interest rate by one and subtract 25% tax rate. That gives, 0.1 (1 – 0.25) = 0.075 = 7.5%

1. What is Lewis’s present value of leasing the equipment?

 PV cost of leasing at 6% = $572,990

1. What is the net advantage to leasing (NAL)? Does your analysis indicate that Lewis should buy or lease the equipment? Explain.

            NAL = PV Ownership Cost – PV Leasing Cost

                    = $(591,741 – 572,990) = $18,751

The NAL is positive, indicating that the equipment’s PV ownership cost is greater than its PV leasing cost, implying that leasing the equipment is less costly than buying and borrowing (Benamraoui et al., 2017). Therefore, Lewis ought to lease the equipment as opposed to purchasing it.

1. What effect would the residual value’s increased uncertainty have on Lewis’ lease-versus-purchase decision?

Residual value adds huge amounts of risk to a purchase (Weng, 2016). The company could end up having no money in return for the equipment at the end of the term, implying that it will be having no money to put back to the debt that it owed on the equipment. If the residual value of the equipment was $400,000, the firm would be lucky. However, there are no ways of preparing for or knowing such a high return. To include this risk in the computation of present value, the company would have to come up with a rate for the risk and multiply the rate into the residual value. Should the equipment’s ownership amount still be more expensive than leasing it, Lewis ought to stay with the lease.

1. In a few sentences, how should you analyze the decision to write or not to write the lease?

The positions of a lessee and lessor are nearly identical. If the lessor desires to now if leasing the equipment would be the right way to go, they ought to enter their data into a timeline just like the timeline that is used to find the PV for lessee position. In the event Consolidate Leasing is capable of making more money by leasing the equipment, they ought to write the lease.