$782,063 for an investment of $250,000 or a ratio of 3.128 to 1. The equipment leasing memorandum contained the following:

Since the sale and leaseback with the Owner is for a period of eight years or longer, at the end of the initial term of User Lease, including any extensions required pursuant to the provisions of any guaranteed residual value sections of the User Lease, but prior to the expiration of the initial term of the Finalco Lease with the Owner, Finalco will be entitled to receive all revenues, if any, generated by the Equipment. As noted above, at the end of the initial term of the Finalco Lease, the Equipment will be re-leased or sold and Finalco will be entitled to a participation in all revenue from such re-leasing or sale of the Equipment in the percentage set forth in the "Summary of the Offering" section and as such participation is more fully described in the Purchase Agreement between Finalco and the Owner.

The Finalco Lease on the Equipment is sufficient to amortize the Owner's Non-Recourse Loan and the User Lease is sufficient to amortize the Lending Institution Loan. These leases, however, will not be for periods of time sufficient to recover the total Equity portion of the Sale Price of the Equipment. In order to yield a net income equal to the total unreturned Equity Portion of the Sale Price, the Equipment must be leased for approximately an additional ten (10) months at the original lease rate. While Finalco believes that the average revenue-producing life of the Equipment being acquired pursuant hereto will be in excess of such term from the date of the Owner's purchase, there can be no assurance that the anticipated net income will, in fact be realized for such period.

It also warned that residual value could not be predicted:

There is no assurance whatsoever that any sale or re-lease of the Equipment can be arranged upon expiration of the Finalco Lease

*

⚫ deterioration, obsolescence and other loss in value of the Equipment over the term of the Finalco lease will certainly occur; the possibility of residual values sufficient to repay the balance of the Equity is speculative, and the amount of any such distributions which may arise is conjectural. [Emphasis by Finalco.]

The memorandum also provided that, upon expiration of the 8-year lease, Rice Toyota would be entitled to only 70 percent of any net proceeds. Finalco retained a 30-percent interest in any such proceeds.

Despite conflicting information regarding residual value and the warnings in the placement memorandum (which he looked at only briefly), Mr. Rice did not obtain an independent appraisal of the equipment's residual value. In deciding to enter into the transaction, Mr. Rice relied primarily on his own intuition, his credence in people, their "track record," background, and reputation.

History of the IBM 370/155

The IBM System 370/155 was announced by IBM in June 1970, and first available for delivery in February 1971. Based upon past experience, IBM customers expected the 370/155 to be the current technology machine from IBM for 5 to 6 years. Barely 2 years after the 370/155 appeared, however, IBM announced the System 370/158. The major differences between the 370/155 and the 370/158 were speed (the 158 was about 40 percent faster), integrated virtual memory (a capacity allowing for more efficient memory), and an integrated circuit memory which was considerably less expensive than the 155's magnetic core memory. In an attempt to protect its 155 market, IBM introduced a "dynamic address translation unit" (DAT box) that could be added to the 155 to provide the virtual memory function to 155 users and also introduced the 155-II with integrated dynamic address translation. Petitioner purchased a 370/155-II.

If brand new, petitioner's IBM computer would have cost approximately $2,500,000. By 1974, however, the IBM 370/155 was regarded as a "half generation" or "older” machine, and its price dropped to 50 to 60 percent of its original cost. In 1975, the 370/158's performance was enhanced by 10 percent. So by 1975, it was apparent that the 370/155 was trailing behind new technology.

Projection of Residual Value

The residual value of a computer is a function of supply and demand, competitive technology, and vendor price. A direct purchaser of a computer would be entitled to a manufacturer's warranty and an investment tax credit (ITC). When a computer is purchased other than directly from the manufacturer, however, the vendor price is often discounted to reflect the absence of these two items. Competitive technology is primarily the rate of decrease in the cost of performance and storage capacity modified by competing maintenance, power, and space costs among equivalent machines. Supply is determined by vendor shipments and turnover of equipment while demand is a function of such factors as growth in the marketplace and the extant level of technology. The residual price for nonobsolete equipment is located between two points, the highest price (vendor price less ITC and warranty) and the lowest price

(the rate of advancing technology). Since the advent of the 1960's space age, technology has been advancing at a rate of about 25 percent per year (measured in dollars per unit of function). The market below the 10-percent residual level is highly distorted because the equipment is sold primarily for parts.

Although there is currently a formula based upon a complex analysis of the used computer market for determining residual values with some degree of accuracy, no such formula existed in 1976 when petitioner entered into this transaction. Participants in the used computer market often made their own forecasts.

The SRI report given to petitioner by Finalco prior to consummation of the deal predicted a residual value for the equipment of 5 or 6 percent by year 14. For petitioner this would be 1984, the year the purchase-leaseback transaction terminated. This predicted residual value, if true, would have been insufficient to cause petitioner to break even, that is, recover its initial capital outlay in the transaction.

The SRI report is actually based upon a composite of computer transactions, surveys of brokers and dealers, and other industry publications. Additional information accompanying the SRI report described market trends for used computer equipment. In describing the trend, among other points, the SRI report contains the following:

Four years after market introduction, however, the value of computer systems begins to drop precipitously. This drop is due to the decision of many potential buyers to postpone purchases until a new family is available, so the demand for computer systems declines during this period. Historically, IBM has followed the marketing practice of introducing a new, more technologically advanced, line of [Central Processing Units] every five or six years. Once the new family has been introduced, computer owners begin to trade upward, placing more and more used equipment on the market as it is replaced by the new generation of computer systems. Thus the precipitous drop in used equipment values continues for about three years, finally reaching a new level at about 20% of the purchase price when new.

The report continues:

In the eleventh year after market introduction, purchasers begin to anticipate the availability of still another new family, causing a further dip in value of the older generation computers.

By year 13, technological innovations in the newer systems have rendered most of the old computers uneconomic to use. Thus their price falls to only slightly more than their scrap value.

The graph on page 193 shows the SRI projected residuals at 5 to 6 percent in 1984. The central processing unit and the peripherals are plotted separately but their curves are similar.

The Transaction

The essence of the transaction that petitioner selected and which gave rise to the issue before us is as follows: Finalco purchased, with bank loans, a used IBM 370/155-II computer processing system at a total cost of $1,297,643. Petitioner, in effect, purchased a 70-percent interest in the computer equipment from Finalco for $1,455,227, payable in a short-term promissory note issued as a downpayment and two nonrecourse installment notes in the amounts of $1,057,741 and $147,486 relating to the main computer equipment and the peripherals, respectively. The terms of the downpayment promissory note were as follows:

The monthly payments on the nonrecourse debt to Finalco were $16,925.07. Simultaneously, petitioner leased the equipment back to Finalco for 8 years at a rental of $17,758.40 per month. The difference between these two amounts (rental and nonrecourse debt) netted a monthly cash flow to petitioner of $833.33 or $10,000 a year for 8 years, which petitioner received in $5,000 installments every 6 months. Except for this $833.33 per month, petitioner did not actually receive the monthly cash rental payments of $17,758.40 described in its lease with

"The central processing system consists of two main components. The central processing unit is the brain function of the computer. The system also includes attachments such as the tape drives and controls that are called peripherals and serve as the workhorse of the system.