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mini-case-ch20 - Chapter 20 Lease Financing MINI CASE Lewis...

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Chapter 20 Lease Financing MINI CASE 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 information from several on-line data services, 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 percent interest rate. Although the equipment has a six-year useful life, it is classified as a special-purpose computer, so it 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 at that time is $200,000. However, since 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 percent. You have been asked to analyze the lease-versus-purchase decision, and in the process to answer the following questions: a. 1. Who are the two parties to a lease transaction? Answer: The two parties are the lessee, who uses the asset, and the lessor, who owns the asset. a. 2. What are the five primary types of leases, and what are their characteristics? Answer: The five primary types of leases are operating, financial, sale and leaseback, combination, and synthetic. An operating lease, sometimes called a service lease, provides for both financing and maintenance. Generally, the operating lease contract is written for a period considerably shorter than the expected life of the leased equipment, and contains a cancellation clause. A financial lease does not provide for Mini Case: 20 - 1
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maintenance service, is not cancelable, and is fully amortized; that is, the lease covers the entire expected life of the equipment. In a sale and leaseback arrangement, the firm owning the property sells it to another firm, often a financial institution, while simultaneously entering into an agreement to lease the property back from the firm. A sale and leaseback can be thought of as a type of financial lease. A combination lease combines some aspects of both operating and financial leases. For example, a financial lease which contains a cancellation clause--normally associated with operating leases--is a combination lease. In a leveraged lease, the lessor borrows a portion of the funds needed to buy the equipment to be leased. A synthetic lease is created when a company creates a special purpose entity (SPE) that borrows and then purchases an asset (usually a long-term asset) and leases it back to the company.
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