Chapter 20, Problem 13IC

### Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250

Chapter
Section

### Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250
Textbook Problem

# FISH & CHIPS INC, PART ILEASE 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?

a.1.

Summary Introduction

To discuss: The reason why leasing is referred as an off-balance-sheet financing.

Introduction:

Off-balance sheet financing is a type of financing where the firm does not include a liability on its balance sheet. This is an accounting term and has impact on firm’s debt level and liabilities.

Explanation

The reason why leasing is referred as an off-balance-sheet financing is as follows:

At the time when an asset is purchased, this asset will be exhibited on the left-hand side balance sheetās left hand side and has to offset equity or debt on the balance sheetās right-hand side...

a.2

Summary Introduction

To discuss: The difference between the operating and capital lease.

Introduction:

Capital lease is termed as contract wherein lesser agrees to transfer ownership right to leasee once the completion of lease time. It is a long term lease contracts. There are also termed as finance lease.

Operating lease is a lease on assets, which is not fully amortized in the non-cancelable period. It is considered as a short term lease.

a.3.

Summary Introduction

To discuss: The effect that leasing has on the capital structure of the firm.

b.1.

Summary Introduction

To determine: The present value cost of owing the computer.

b.2.

Summary Introduction

To discuss: The rationale for the discount rate that is utilised to determine the present value.

c.1.

Summary Introduction

To determine: The present value cost of leasing the computer.

c.2.

Summary Introduction

To determine: The net advantage to leasing and whether the analysis indicates that the firm must purchase or lease the computer.

d.

Summary Introduction

To discuss: The way for accomplishing the task and effect that will have on the leasing decision.

e.

Summary Introduction

To discuss: The effect of a cancellation clause has on the risk of the lease.

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