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FISH & CHIPS INC, PART I
LEASE ANALYSIS Martha Millon, financial manager for Fish it 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 4c Chips′s 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's present value cost of owning the computer? (Hint: Set up a table whose bottom line is a “time line" that shows the cash flows over the period t = 0 to t = 4. Then find the PV of these 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′s 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 that 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 risk of the lease?
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Chapter 20 Solutions
Fundamentals of Financial Management (MindTap Course List)
- Lease versus Buy Consider the data in Problem 19-1. Assume that RCs tax rate is 40% and that the equipments depreciation would be 100 per year. If the company leased the asset on a 2-year lease, the payment would be 110 at the beginning of each year. If RC borrowed and bought, the bank would charge 10% interest on the loan. In either case, the equipment is worth nothing after 2 years and will be discarded. Should RC lease or buy the equipment?arrow_forwardOwens Company leased equipment for 4 years at 50,000 a year with an option to renew the lease for 6 years at 2,000 per month or to purchase the equipment for 25,000 (a price considerably less than the expected fair value) after the initial lease term of 4 years. Why would this lease qualify as a finance lease?arrow_forwardUse the information in RE20-6. However, assume that there is no bargain purchase option and that Montevallo guarantees the 20,000 estimated residual value at the end of the 10-year lease. Montevallo estimates that it is probable that it will have to pay 15,000 cash due to the residual value guarantee. Calculate the present value of the lease payments. Round your answer to the nearest dollar.arrow_forward
- Big Sky Mining Company must install 1.5 million of new machinery in its Nevada mine. It can obtain a bank loan for 100% of the purchase price, or it can lease the machinery. Assume that the following facts apply. (1) The machinery falls into the MACRS 3-year class. (2) Under either the lease or the purchase, Big Sky must pay for insurance, property taxes, and maintenance. (3) The firms tax rate is 25%. (4) The loan would have an interest rate of 15%. It would be nonamortizing, with only interest paid at the end of each year for four years and the principal repaid at Year 4. (5) The lease terms call for 400,000 payments at the end of each of the next 4 years. (6) Big Sky Mining has no use for the machine beyond the expiration of the lease, and the machine has an estimated residual value of 250,000 at the end of the 4th year. a. What is the cost of owning? b. What is the cost of leasing? c. What is the NAL of the lease?arrow_forwardReynolds Construction (RC) needs a piece of equipment that costs 200. RC can either lease the equipment or borrow 200 from a local bank and buy the equipment. Reynoldss balance sheet prior to the acquisition of the equipment is as follows: a. (1) What is RCs current debt ratio? (2) What would be the companys debt ratio if it purchased the equipment? (3) What would be the debt ratio if the equipment were leased and the lease not capitalized? (4) What would be the debt ratio if the equipment were leased and the lease were capitalized? Assume that the present value of the lease payments is equal to the cost of the equipment. b. Would the companys financial risk be different under the leasing and purchasing alternatives?arrow_forwardDifferential analysis for a lease or sell decision Burlington Construction Company is considering selling excess machinery with a book value of 115,000 (original cost of 275,000 less accumulated depreciation of 160,000) for 90,000, less a 6% brokerage commission. Alternatively, the machinery can be leased for a total of 100,000, for four years, after which it is expected to have no residual value. During the period of the lease, Burlington Construction Companys costs of repairs, insurance, and property tax expenses are expected to be 9,000. a. Prepare a differential analysis dated January 15 to determine whether Burlington Construction Company should lease (Alternative 1) or sell (Alternative 2) the machinery. b. On the basis of the data presented, would it be advisable to lease or sell the machinery? Explain.arrow_forward
- Grummet Company is acquiring a new wood lathe with a cash purchase price of $80,000. The Wood Master Industries (the manufacturer) has agreed to accept $23,500 at the end of each of the next 4 years. Based on this deal, how much interest will Grummet pay over the life of the loan? A. $94,000 B. $80,000 C. $23,500 D. $14,000arrow_forwardLease versus purchase Northwest Lumber Company needs to expand its facilities. To do so, the firm must acquire a machine costing $80,000. The machine can be leased or purchased. The firm is in the 21% tax bracket, and its after-tax cost of debt is 9%. The terms of the lease and purchase plans are as follows: Lease The leasing arrangement requires end-of-year payments of $19,800 over 5 years. All maintenance costs will be paid by the lessor; insurance and other costs will be borne by the lessee. The lessee will exercise its option to purchase the asset for $24,000 at termination of the lease. Purchase If the firm purchases the machine, its cost of $80,000 will be financed with a 5-year, 14% loan requiring equal end-of-year payments of $23,302. The machine will be depreciated under MACRS using a 5-year recovery period. (See Table 2 for the applicable depreciation percentages.) The firm will pay $2,000 per year for a service contract that covers all maintenance costs; insurance and other…arrow_forward
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