Lewis Securities Inc. has decided to acquire a new market data and quotation system for its Richmond home office. The system receives current market prices and other informa- tion from several online data services and then either displays the information on a screen or stores it for later retrieval by the firm’s brokers. The system also permits customers to call up current quotes on terminals in the lobby.
The equipment costs $1,000,000 and, if it were purchased, Lewis could obtain a term loan for the full purchase price at a 10% interest rate. Although the equipment has a 6-year useful life, it is classified as a special-purpose computer and therefore falls into the MACRS 3-year class. If the system were purchased, a 4-year maintenance contract could be obtained at a cost of $20,000 per year, payable at the beginning of each year. The equipment would be sold after 4 years, and the best estimate of its residual value is $200,000. However, because real-time display system technology is changing rapidly, the actual residual value is uncertain.
As an alternative to the borrow-and-buy plan, the equipment manufacturer informed Lewis that Consolidated Leasing would be willing to write a 4-year guideline lease on the equipment, including maintenance, for payments of $260,000 at the beginning of each year. Lewis’s marginal federal-plus-state tax rate is 40%. You have been asked to analyze the lease-versus-purchase decision and, in the process, to answer the following questions:
(1) Assume that the lease payments were actually $280,000 per year, that Consolidated Leasing is also in the 40% tax bracket, and that it also forecasts a $200,000 residual value. Also, to furnish the maintenance support, Consolidated would have to purchase a maintenance contract from the manufacturer at the same $20,000 annual cost, again paid in advance. Consolidated Leasing can obtain an expected 10% pre-tax return on investments of similar risk. What would be Consolidated’s
NPV and IRR of leasing under these conditions?
(2) What do you think the lessor’s NPV would be if the lease payment were set at $260,000 per year? (Hint: The lessor’s cash flows would be a “mirror image” of the lessee’s cash flows.)