Jagannath University
Course Name: Principle of Finance
Course Code: FIN-6101
Submitted By
SL NO ID NO. Name of Student
Submitted To:
1 M2507020156 Sayma Akter DR. MOHAMMAD MONJUR
2 M2507020162 Shoumi Paul MORSHED BHUIYA
Professor (Grade-II)
3 M2507020170 Nuzhat Anjum Rashin
Department of Finance
4 M2507020171 Ummah Hasiba Jagannath University
5 M2507020153 Suborna Mostofa
Assignment on: Chapter-07 (Lease Financing)
Case Overview
Kris Crawford, the capital acquisitions manager at Heath Financial Services Inc., has been assigned to
evaluate whether the company should purchase or lease a new stock price quotation system for its Sarasota
branch. The system would display real-time stock prices in the office lobby for client reference and use.
Option 1:
Buying the Equipment - Total Cost: $1,200,000
Financing: 4-year term loan at 10% annual cost
Payment: Year-end basis
Depreciation: MACRS 3-year class
Maintenance: $25,000 annually (paid at beginning of each year)
Estimated Residual Value after 4 years: $125,000 (but uncertain due to tech changes)
Option 2:
Leasing the Equipment - Lessor:
National Leasing - Term: 4 years
Lease Payment: $340,000 annually (including maintenance)
Payment Timing: Beginning of each year
Ownership: No ownership; asset returned to lessor
Common Assumptions:
Marginal Tax Rate: 40%
Objective: Determine the least-cost option considering cash flows, tax benefits, and strategic risks .
Q: (a-1) Why is lease financing often referred to
as off-balance-sheet financing?
Lease financing is often called off-balance-sheet financing because:
Off-balance-sheet financing refers to lease agreements (mainly operating leases) that
are not recorded as liabilities on the balance sheet.
Operating leases
This reduces reported debt
Capital (finance) leases
Key distinction: Operating lease = rent; Capital lease = ownership-like.
Q: (a-2) What is the difference between a capital
lease and an operating lease?
Difference Between a Capital Lease & an Operating Lease are given below:
Capital Lease: Operating Lease:
is a long-term contractual agreement, is a type of lease agreement that allows
where a lessee rents an asset from a the lessee to use an asset for a specified
lessor for a specified period period of time without transferring
Non-Cancellable ownership.
Lessee depreciates the asset Cancellable
Often includes purchase option Lessor depreciates the asset
Lessee typically responsible for No purchase option
maintenance and risk Lessor typically responsible for
maintenance and risk
Q: (a-3) What Effect does Leasing have on a
Firm’s Capital Structure?
Leasing impacts a firm's capital structure by altering its debt-to-equity ratio
and other leverage metrics.
Leasing creates long-term payment obligations
Leased assets often bypass traditional debt classification
Financial analysts treat lease payments like debt
Leasing increases financial obligations
Q: (b-1) What is Heath’s present value cost of owning the equipment?
(Hint: First, set up a table that shows the net cash flows over the period
t = 0 to t = 4, and then find the PV of these net cash flows at t = 0.)
If we want to find out the Heath’s present value cost of owning the equipment
then we must determine the instalment payment & after-tax cash outflows
Here,
PVA = $12,00,000
A=?
i = 10%
n = 4 years
So, The Value of Instalment is $3,78,565
CONT...
Loan Amortization Table: Interest rate @10% for 4 years
Installment Beginning of End of Year
Year Interest (10%) Principal
Payment Year Principal Principal
1 $378,565 $1,200,000 $120,000 $258,565 $941,435.04
2 $378,565 $941,435 $94,143.50 $284,421.50 $657,013.57
3 $378,565 $657,013.50 $65,701.36 $312,863.65 $344,149.97
4 $378,565 $344,150 $34,415 $344,150 $0.00
CONT...
CONT.... After Tax cash outflow Calculation:
Tax After Tax
Maintenance Total
Year Loan Payment Depreciation Interest Shield Cash
Cost Deduction
(40%) Outflow
0 25,000 0 0 25,000 10,000.00 15,000.00
1 378,565.00 25,000 399,960 120,000 544,960 217,984.00 185,581.00
2 378,565.00 25,000 533,400 94,144 652,544 261,017.60 142,547.40
3 378,565.00 25,000 177,720 65,701 268,421 107,368.40 296,196.60
4 378,565.00 0 88,920 34,415 148,335 59,334.00 254,231.00
Note: 75,000 has been adjusted in the year of 4. As the Maintenance Cost has to paid in the beginning of the
period , so the Maintenance Cost is calculated in the 0,1,2,3 year.
CONT... Present Value Calculation of Owning the Equipment:
Here,
Year = 0-4
i = 6%
So, Heath’s Present Value Cost of Owning the equipment is 767,010.2347.
Q: (b-2) Explain the Rationale for the discount Rate. Used to find the
PV.
In the above calculation, we used a discount rate of 6%. This
rate is the after-tax cost of debt. It is calculated as follows:
Discount rate = Debt rate × (1 - tax rate)
=10%×(1−0.40)
=10%×0.60
=6%
Q: (C-1) What is Heath’s Present Value Cost of Leasing the
Equipment? (Hints: Again, Construct Cash Flow Timeline)
After Tax cash outflow Calculation for Leasing:
Cashoutflow Timline:
CONT... Present Value Calculation of Lease Financing:
Here,
As the Instalment has to paid in the beginning of the period , so
the Instalment is calculated in the 0,1,2,3 year.
i = 6%
So, The PV of Lease Financing is 749,294.4
Q: (C-2) What is the Net Advantage to Leasing? Does your Analysis
indicate that Heath should buy or lease the equipment? Explain.
Net Advantage to Leasing (NAL) is the difference between the present value of the
cost of owning an asset and the present value of leasing it.
NAL=NPV of Buying−NPV of Leasing
Here NAL is Positive. If Heath leases the equipment, then the incremental
savings will be 17,715.7970. So, Heath should lease the equipment rather
than purchase it.
Q: (d) Now assume that Crawford believes the equipment'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 could be accomplished.
What effect would it have on Heath's lease decision?
To incorporate the differential risk of the residual value into the analysis, Crawford can
apply a higher discount rate to the residual value compared to the discount rate used for
other, less risky cash flows,
Identify the extra risk — that’s called a risk premium
Use a higher discount rate just for the residual value
And rely on the expected value for more accurate estimation.
CONT...
Effect on Heath's Lease Decision:
Leasing becomes more attractive
This weakens the case for purchasing
the equipment
By factoring in the higher risk, Heath
might lean more towards leasing the
equipment rather than buying
Q: (e) Crawford knows that her firm has been considering moving to a new downtown
location for some time, and she is concerned that these plans might come to fruition prior to
the expiration of the lease. If the move occurs, the company would obtain completely new
equipment, and hence Crawford would like to include a cancellation clause in the lease
contract. What effect would a cancellation clause have on the riskiness of the lease?
Contractual Risk of Leasing:
If Crawford's firm relocates before lease ends, penalties may
apply. Early termination can lead to additional costs,
increasing overall lease expenses.
Advantage of Purchasing Equipment:
Offers full ownership and control. No penalties for resale or
relocation. Better strategic choice if relocation is likely.
Strategic Recommendation:
Evaluate the likelihood and cost of relocation. If flexibility
is critical, consider purchasing over leasing.
Conclusion
Leasing is shown to be more cost-effective and flexible than buying, saving Heath’s Financial
Services Inc. $17,715.80 in present value terms. It reduces risk related to residual value and
offers flexibility through cancellation clauses. Leasing also improves capital structure and
preserves liquidity. The analysis emphasizes evaluating both financial and strategic factors in
investment decisions.
References
Essentials of Managerial Finance Besley & Brigham 14th edition.
Brigham, E. F., & Ehrhardt, M. C. (2017). Financial Management: Theory
& Practice (15th ed.). Cengage Learning,.
Brigham, E. F., & Ehrhardt, M. C. (2014). Financial Management: Theory
& Practice (14th ed.). Cengage Learning.
Any Questions?
