Warf Computers has decided to proceed with the manufacture and distribution of t

Question

Warf Computers has decided to proceed with the manufacture and distribution of the virtual keyboard (VK) the company has developed. To undertake this venture, the company needs to obtain equipment for the production of the microphone for the keyboard. Because of the required sensitivity of the microphone and its small size, the company needs specialized equipment for production. Nick Warf, the company president, has found a vendor for the equipment. Clapton Acoustical Equipment has offered to sell Warf Computers the necessary equipment at a price of $3.6 million. Because of the rapid development of new technology, the equipment falls in the three-year MACRS depreciation class. At the end of four years, the market value of the equipment is expected to be $440,000. Alternatively, the company can lease the equipment from Hendrix Leasing. The lease contract calls for four annual payments of $935,000, due at the beginning of the year. Additionally, Warf Computers must make a security deposit of $210,000 that will be returned when the lease expires. Warf Computers can issue bonds with a yield of 11 percent, and the company has a marginal tax rate of 35 percent.

1. Should Warf buy or lease the equipment? 2. Nick mentions to James Hendrix, the president of Hendrix Leasing, that although the company will need the equipment for four years, he would like a lease contract for two years instead. At the end of the two years, the lease could be renewed. Nick would also like to eliminate the security deposit, but he would be willing to increase the lease payments to $1,650,000 for each of the two years. When the lease is renewed in two years, Hendrix would consider the increased lease payments in the first two years when calculating the terms of the renewal. The equipment is expected to have a market value of $1.44 million in two years. What is the NAL of the lease contract under these terms? Why might Nick prefer this lease? What are the potential ethical issues concerning the new lease terms? 3. In the leasing discussion, James informs Nick that the contract could include a purchase option for the equipment at the end of the lease. Hendrix Leasing offers three purchase options: a. An option to purchase the equipment at the fair market value. b. An option to purchase the equipment at a fixed price. The price will be negotiated before the lease is signed. c. An option to purchase the equipment at a price of $200,000. How would the inclusion of a purchase option affect the value of the lease? 4. James also informs Nick that the lease contract can include a cancellation option. The cancellation option would allow Warf Computers to cancel the lease on any anniversary date of the contract. In order to cancel the lease, Warf Computers would be required to give 30 days’ notice prior to the anniversary date. How would the inclusion of a cancellation option affect the value of the lease?

Explanation / Answer

Since, t

Part 1)

In order to take the decision as to leasing or buying the equipment, we need to determine the incremental cash flows as follows:

We need to calculate NAL of the lease as follows:

After-Tax Cost of Debt = 11%*(1-35%) = 7.15%

NAL = 2,782,250 - 1,027,708/(1+7.15%)^1 - 1,167,820/(1+7.15%)^2 - 794,356/(1+7.15%)^3 - 379,366/(1+7.15%)^4 = -127,556.52

The company should buy the equipment as NAL is negative.

___________

Part 2)

The book value of the equipment after 2 years would be:

Book Value = 3,600,000 - 3,600,000*(.3333 + .4445) = $799,920

After-Tax Salvage Value in 2 Years = 1,440,000 - 35%*(1,440,000 - 799,920) = $1,215,972

We will have to calculate revised NAL with respect to the revised values. The incremental cash flows are determined as follows:

The NAL is calculated as follows:

NAL = 2,527,500 - 1,492,458/(1+7.15%)^1 - 1,776,042/(1+7.15%)^2 = -$412,291.60

Going by the above calculations, it might be concluded that it is favorable to buy the equipment as NAL is negative. However, the lease will now be classified as an operating lease as the lease is for 2 years which is less than 75% of the economic life of the asset. Now, we will determine the present value of lease payments with use of company's cost of debt as follows:

Present Value of Lease Payments = 1,650,000 + 1,650,000/(1+11%)^1 = $3,136,486.49

The present value of lease payments is less than 90% (3,600,000*90% = $3,240,000) of the cost of equipment. In case, the lease contract allows for transfer of ownership to lesses at the termination of the contract or there is an option for bargain purchase, the lease cannot be treated as a capital lease (as per the relevant accounting standard requirements). Therefore, the suggestion to revise the lease terms in order to make it appear an an operating lease is not ethical on Nick's part as it would result in the lease obligation not getting reported in the balance sheet.

___________

Part 3)

a) The inclusion of a right to purchase the equipment will have no effect on the value of the lease. It is so because, if there is no such right, the company is free to purchase a similar type of equipment from the market at a similar price.

b) The right to purchase the equipment at a fixed price will result in an increase in the value of the lease. If the company has the right to purchase the equipment at the termination of the lease at below the prevailing market value, it will result in savings for the company. Another option would be to purchase the equipment at the fixed price and resell in the open market at a higher value. This would be treated as a real (call) option in the hands of the lessee. Further, it would take the form of a capital lease.

c) The right to purchase the equipment at a bargain price would also be treated as a real (call) option in the hands of the lessee. It will result in an increase the value of the lease. The terms of the lease would indicate that this is a capital lease.

___________

Part 4)

Inclusion of cancellation option will also be treated as a real (put) option in the hands of the lesser. It will result in an increase the value of the lease as the option would be exercised (by the lessee) when it offers some advantage to the lessee.

Year 0 Year 1 Year 2 Year 3 Year 4 Saved Purchases 3,600,000 Loss of Salvage Value -286,000 (440,000 - 440,000*35%) Loss Depreciation Tax Shield -419,958 (3,600,000*.3333*35%) -560,070 (3,600,000*.4445*35%) -186,606 (3,600,000*.1481*35%) -93,366 (3,600,000*.0741*35%) Security Deposit -210,000 Lease Payment -935,000 -935,000 -935,000 -935,000 Tax on Lease Payment 327,250 327,250 327,250 327,250 Cash Flow from Leasing $2,782,250 -$1,027,708 -$1,167,820 -$794,356 -$379,366

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