Reference no: EM133111698

Leasing Case

Mr. Bai Li emigrated from Malaysia to Canada in 1993. He landed in Edmonton, Alberta, and started his working life in Canada a national grocery store chain. He stayed with the same company for 10 years, working first as a stocker, then at the check-out counter, then becoming a supervisor and finally, the branch manager. When he had saved up enough money, Mr. Li quit his job and moved to Bonnyville, Alberta to open his own grocery store in 2003. He named the store Fast and Furious Supermarket, after his favourite movie. In 2009, after six years of being in business on his own, Mr. Li (who preferred to be called Richard) had established himself as a respectable businessman and a pillar of the local community. His friendly demeanour and gregarious nature had contributed to the popularity of his store as a grocery shopping destination for local residents and shoppers from many surrounding counties. Richard had also established a good business relationship with the local branch of the Bank of Scotia. 

Richard is now thinking of replacing the aging refrigeration units in his store. He inherited the equipment from the previous store owner, who purchased them in 2002. The units have broken down numerous times recently, necessitating extensive repairs costing almost $5,000, without accounting for the loss of inventory and business during the breakdown. Richard is trying to decide whether he should borrow money from his bank to buy the new refrigeration units outright, or to lease them. After some research on the Internet, Richard found a great leasing deal offered by the National Refrigeration Company (NRC). After several phone conversations and a face-to-face meeting, NRC's leasehold manager, Mr. Fife, sent the following details on the proposed lease:

• Type of lease: Short-term, cancellable with two-weeks' notice
• Length of lease: six years
• Lease payment: $5,500 per month, payable at the beginning of every month
• Purchase option: $50,000 at the end of the sixth year
• Maintenance and upkeep will be performed by NRC at no cost to Fast and Furious Supermarket. 
• NRC will be responsible for the insurance of the equipment.

Richard estimates that the new refrigeration units will save him $20,000 in lower electricity bills as well as lower spoilage and maintenance costs per year, not to mention fewer headaches if the units ever broke down. The new units are also more spacious and would allow Richard to stock more frozen foods that are popular with his customers. He estimates that his revenues would increase by at least $60,000 per year with these new units. He also estimates that the old refrigeration units would not have any resale value.

Being "old school," Richard would prefer to simply borrow money from the bank, buy the new units outright, and then use the extra revenues earned from the new units to pay back the bank as quickly as possible. He asked NRC how much it would cost if he purchased the units outright, and was quoted a price of $300,000, which included the installation service provided by NRC. He then went to talk with the loan manager at his bank, who informed him that he should be able to borrow the funds at 12% APR compounded annually. 

Richard estimates that after six years, he could sell the equipment for $45,000, after which he would have to replace the units again. If he purchases the units, he estimates that he would have to pay annual maintenance costs of about $3,500. After checking the website of the Canada Revenue Agency (CRA), Richard found that the units could be depreciated at a CCA rate of 30%, and the half-year rule would apply to the first year's depreciation amount. Based on last year's Statement of Comprehensive Income, the company's marginal tax rate was 35%.   

Before making the decision to buy or lease, Richard would like to carefully weigh the pros and cons of leasing versus borrowing and buying. However, the decision must be made soon, as the old refrigeration units are "on their last legs"! 

Questions:

1. What are the two basic types of leases? Describe these two types of leases and explain their differences.    
2. Based on the information given, which type of lease is NRC offering Richard?                                               
3. Identify all relevant and irrelevant cash flows to the lease versus buy decision. Categorize the cash flows into cash inflows and outflows, and explain why each cash flow belongs to the category you have placed it in.   
4. Explain the tax effects on the cash flows relevant to the lease versus buy decision.                                                                        
5. What is the correct discount rate to use in calculating the present value of the relevant cash flows in a lease versus buy decision? Explain.                                       
6. Calculate the Net Advantage to Leasing (NAL) of the new refrigeration units. Assume that the maintenance costs are paid at the end of each year.                          
7. What is the maximum lease payment that Richard should pay?                                                              
8. If NRC's tax rate is also 35%, what would be the NAL from the point of view of the lessor, assuming that all the relevant cash flows remain the same? What principle is demonstrated here?                                         
9. If NRC's tax rate is 40%, what is the minimum lease payment that it would accept? Assume that due to NRC's favourable position in the industry, it will be able to resell the equipment for $55,000 after six years.      
10. If Richard leases the refrigeration units, how will this affect his debt capacity?                                                                       
11. What factors, aside from the NAL, must Richard consider before making the lease versus buy decision?     
12. Should Richard lease or buy the refrigeration units?