Lewis’s management has been considering moving to a new downtown location, and they are concerned that these plans may come to fruition prior to the expiration of the lease. If the move occurs, Lewis would buy or lease an entirely new set of equipment, and hence management would like to include a cancellation clause in the lease contract. What impact would such a clause have on the riskiness of the lease from Lewis’s standpoint? From the lessor’s standpoint? If you were the lessor, would you insist on changing any of the lease terms if a cancellation clause were added? Should the cancellation clause contain any restrictive covenants and/or penalties of the type contained in bond indentures or provisions similar to call premiums?

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 cancellation clause would lower the risk of the lease to Lewis, the lessee, because then it would not be obligated to make the lease payments for the entire term of the lease. If its situation changed, so that Lewis either no longer needed the equipment or else wanted to change to a more technologically advanced product, then it could terminate the lease.
However, a cancellation clause would make the contract more risky for the lessor. Now the lessor bears not only the final residual value risk, but also the uncertainty of when the contract will be terminated.
To account for the additional risk, the lessor would undoubtedly increase the annual lease payment. Additionally, the lessor might include clauses that would prohibit cancellation for some period and/or impose a penalty fee for early cancellation. The decision as to whether or not to include a cancellation clause would depend on who was in a better position to bear the residual value risk, the lessee or the lessor. Often lessors have more expertise at disposing of used equipment than lessees, and thus they are willing to include cancellation clauses without major increases in the required lease payments.