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Operating Versus Finance Leases and Valuation: In Year 0, a company entered into a perpetual lease on certain property. The property has a value of $25,000, the cost of debt is 12%, and its annual lease payment is $3,000. The company expects all of the cash flows to grow at 3% in perpetuity and it expects to increase the amount of leased property at the same rate beginning at the end of Year 1 (all new leases are perpetual leases). The company has revenues of $5,000 in Year 1 and has no other expenses other than those related to the lease. The companys tax rate on all income is 45%. All revenues and expenses are paid in cash. The company has no assets or liabilities other than those related to the lease. Assume today is the end of Year 0. The company has a 22% equity cost of capital, and the discount rate for interest tax shields is equal to the unlevered cost of capital. Value the company as of the end of Year 0 assuming the company treats the lease as an operating lease, and value the company again assuming the company treats the lease as a capital or finance lease, treating the present value of the lease payments as debt. As part of the valuation, prepare the companys income statement and free cash flow schedule for Year 1 under each lease treatment. Use the weighted average cost of capital, equity DCF, and APV valuation methods to value the company.

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