Lewis Securities Inc case

Document Type:Coursework

Subject Area:Finance

Document 1

A lease agreement involves two parties. These parties are the lessor and the lessee. Where the lessor refers to the owner of the assets or property who is receiving payments from the lease. On the other hand, the lessee refers to the party that is leasing the assets. In this case, Lewis Securities Inc. is the lessee while the second party is the owner, who is the individual or firm that owns the equipment. Primary examples of lease agreements and their distinguishing features. Leases can be classified into several categories but the main leases are; operating lease is a lease contract that is designed to cover a period that is less than the expected useful life of the equipment that is leased. Within the lease period, both financing and maintenance of the leased equipment is offered. the costs of maintenance are included in the lease payments arrangements. The lease cannot be fully amortized since this lease arrangement has a cancellation clause meaning that it can be cancelled at any time by the parties involved. Hence, it covers a shorter period. Also, this type of lease if referred to as service lease. The financial lease which is also referred to as capital lease as it covers the entire useful life of the asset. In this lease arrangement, there is no provision for maintenance service. This lease agreement is not cancelable, that is, no cancellation clause. This type of lease is fully amortized because it covers the entire period of the leased asset.

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Sale and leaseback agreement. This is type of lease where the lessor possess right to sell asset to another party which is usually a financial institution. The lessor then enters into an agreement with the new owner (Financial institution) to lease the asset back thus becoming the lessee now. This means that both the lease payments and depreciation of the leased asset are treated as tax deductible under IRS genuine lease guidelines. It should be noted that a guideline lease is also referred to as a lease that is tax centered. The effect of the lease on the firm’s balance sheet. On balance sheet, financial lease which is also referred to as capital, is recorded directly. On the other hands, Operating lease is listed in the footnotes. Through the analysis of the capital structure, one is able to determine how the company is risky.

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For instance, if the company is financed largely by debt, then the firm posse a greater risk to investors. In order to keep in touch with the capital structure of the firm, investors can monitor the Debt – to – Equity ratio. The risks if carefully mitigated can be the main foundation of the firm’s growth. In addition to debt financing, the firm can instead use lease agreement as a form of financing its capital structure. Amount of Loan payment = 6% of $1,000,000 = $60,000 Maintenance expense = $20,000 After tax maintenance cost = 20,000 *(1- 40%) = $12,000 Figures given in thousands of dollars (2) The basis for the use of the discount rate so as to get the PV. The rationale for discount rate that have used to find the PV is that since lease financing is the same as debt financing which attracts a tax shield on the interest payment then the after-tax cost of debt will be given by 10% (1 – T) = 10% * (1 - 40%) = 6%.

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This is so since cashflows are given on after tax basis. Note that the normal discount rate is dependent on the general level of interest rates as well as the riskiness of cash flow. Both the loan repayments as well as the maintenance cost are both fixed lease agreement thus making the two non - risky. Net Cash Flow ($156) ($156) ($156) ($156) $0 PV @6% 1. PV Value of Leasing ($156) -$156*0. This means that the PV cost of Leasing the equipment at a discount rate of 6% is $572. or $572. d. The residual value of the inflow, that is the positive CF should be raised so as to account for the increased risk. Thus, the increased discount rate is applied will lead to a lower present value of the residual cash flow resulting to a higher cost of owning the equipment.

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Thus, this means that the greater the risk involved in the residual value, the higher the cost of owning the equipment, hence making leasing more attractive. If the negative CF was included as a cash outflow in calculation of the cost of leasing cash flows, then a lower discount rate would be applied due to the increased risk that is reflected on the residual cashflows, that is, the riskiness of this residual value of Lewis lease plan would penalize him rather than help his lease agreement. All the other cash flows that are involved in the project should be discounted at the original 6% rate. Residual Value tax -$80,000 Cash flow. No Residual -$12,000 $60,000 $108,000 -$12,000 -$1,112,000 Cash Flow. Residual $200 Present Value @6% 1. PV less Residual Figures in ‘000’ ($12) * 1. PV of Residual @6% = 0. It is of important to make note that expenses on depreciation that was earlier determined will also be applied to the lessor.

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Useful in calculation Payment on Lease = $280,000 Corporate tax Rate = 40% Pre - tax interest rate (Lease) = 10% After-tax discount rate = 6% Figures are given in thousand dollars. Yrs. Yrs. Yrs. Assume discount rate is 10% Year Yrs. Yrs. Yrs. Yrs. Yrs. A times, the lessor is forced to forbid cancellation of the lease agreement for some period of time as well as inclusion of penalty fee on early cancellation of the lease. This inclusion of penalty fee on the cancellation clause depends on who is in a better position to incur the residual value risk between the lessor and lessee. In most cases, the owners of the asset have the knowledge and manpower on disposition of used assets than the lessees hence making the lessors to have a higher taste for insertion of cancellation clause without any need for increment in the annual lease payments.

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