Warf Computers has decided to proceed with the manufacture and distribution of t
ID: 2417142 • Letter: W
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 $4 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 $480,000.
Alternatively, the company can lease the equipment from Hendrix Leasing. The lease contract calls for four annual payments of $1,040,000, due at the beginning of the year. Additionally, Warf Computers must make a security deposit of $240,000 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 $1,840,000 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 $1.6 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 $200,000. How would the inclusion of a purchase option affect the value of the lease?
4. James also informs Nick that the lease contract can include a cancellation option. The cancellation option would allow Warf Computers to cancel the lease on any anniversary date of the contract. In order to cancel the lease, Warf Computers would be required to give 30 days’ notice prior to the anniversary date. How would the inclusion of a cancellation option affect the value of the lease?
Explanation / Answer
Year Year 0 Year 1 Year 2 Year 3 Year 4 Buy ($) ($) ($) ($) ($) Cost of Equipment -4000000 *After Tax Operating Savings 312000 *Depreciation Tax Benefit 466200 621600 207200 103600 -4000000 466200 621600 207200 415600 Lease Deposit -240000 240000 Lease Payments -1040000 -1040000 -1040000 -1040000 Tax benefit of Lease payments(Lease payments*0.35) 364000 364000 364000 364000 -916000 -676000 -676000 -676000 240000 Year Year 0 Year 1 Year 2 Year 3 Year 4 Lease - Buy ($) ($) ($) ($) ($) Lease Deposit -240000 240000 Lease Payments -1040000 -1040000 -1040000 -1040000 Tax benefit of Lease payments(Lease payments*0.35) 364000 364000 364000 364000 (-)Buy Cost of Equipment 4000000 *After Tax Operating Savings -312000 *Depreciation Tax Benefit -466200 -621600 -207200 -103600 Total 3084000 -1142200 -1297600 -883200 -175600 Working Notes: *After Tax Operating Savings ($480000)*(1-0.35) 312000 *Depreciation Tax Benefit (MACRS) Year 1 33.3% * 4000000 1332000 (1332000*35% 466200 Year 2 44.4% * 4000000 1776000 (1776000*35% 621600 Year 3 14.8% * 4000000 592000 (592000*35% 207200 Year 4 7.4% * 4000000 296000 (296000*35% 103600 Net present value (NPV) After tax rate[11% x (1-35%)] 7.15 NPV = 3084000 - [1142200 / (1+0.0715)] - [1297600 / (1+0.0715)2] - [883200 / (1+0.0715)3] - [175600 / (1+0.0715)4] NPV = 3084000 - 1065982 - 1130203 - 717930 - 133215 NPV = $36,668 Actual interest rate is a 11%, but if corporate tax rate is 35% , the correct discount rate is the aftertax rate of 7.15%. When 7.15% is used to compute the NPV , we get NPV which is $22917.57. Because the net present value of the incremental cash flows is positive, the company of Warf Computers must prefers to buy the equiptment. The book value of the equipment in year 2 will be: Book Value = ($4000000 - $4000000 (0.3333+0.4444) 889200 So, the aftertax salvage value of the equipment in year 2 will be: After Tax Salvage value 1600000 + (889200 - 1600000) * 0.35 1244600 Therefore, the NAL of the lease under these terms is: Year 0 Year 1 Year 2 Saved Purchases 4000000 (-) Salvage value (-) depreciation Tax shield -466200 -621600 Lease Payments -1840000 -1840000 Tax on lease payments -644000 -644000 Cash floe from Lease NAL = –$291,533.21 Why might Nick prefer this lease? What are the potential ethical issues concerning the new lease terms? The NAL of the lease is negative figure, so it will be less favorable for the lessee under these terms. However, the lease will be most likely to be classified as an operating lease Under FAS 13 (Financial Accounting Standard 13), certain leases are classified as capital lease. FAS 13 states that a lease must be classified as a capital one if at least one if the following four criteria is met: -The present value of the lease payment is at least 90 percent of the fair market value of the asset at the start of the lease -The lease transfer ownership of the property to the lessee by the end of the term of the lease -The lease term is 75 percent or more of the estimated economic life of the asset. -The lessee can purchase the asset at a price below fair market value when the lease expires. This frequently called a bargain purchase price option. The lease is now for two years only, which is less than 75 percent of the equipment’s life according to the question. Operating leases are usually not fully amortized as the term is usually less than the economic life of the asset. By using the company’s cost of debt, the present value of the lease payments is: PV of lease payments = $18400000 + $1840000/1.11 $ 3,497,658 This figure ($3,497,658) is less than 90 percent of the price of the equipment ($4,000,000), which is 87.44% of the price. As long as the lease contract does transfer ownership to the lessee at the end of the contact, or allow for a purchase at a bargain price, the FAS 13 conditions for a capital lease are not met. Accountants generally argue that a firm’s financial strength is inversely related to the amount of its liabilities. Because of the lease liability is hidden with an operating lease, the balance sheet of a firm with an operating lease looks stronger than the balance sheet of a firm with an otherwise identical capital lease. Given the choice, firms would probably classify all their leases as operating one, so do Nick. Therefore, the reason for suggesting the revised lease terms is unethical on Nick’s part. In addition, the question also states that if the lease is renewed in two years, the lessor will allow for the increased lease payments made over the first two years. This is also an indication that the revision is for less than ethical reasons. a)At the fair market value 1) Option does not provide the purchase price in advance 1) Option does not provide the purchase price in advance 2) the lessor will not receive less than the asset is worth 3) no effect on the value of the lease 4) attractive option if a) keep payments low b) avoid equipment obsolescence b) at fixed price. The price will be negotiated before the lease is signed -Increase the value of the lease. -Purchase equipment at the end the of the lease at below market value > save money -Purchase at minimum value > purchase it at the fixed price and resell it in open market -Real option > has value to the lessee -Option on the equipment -Must have value until it expires or exercised -Make the lease contract a capitalized lease c) at a price of $125,000. -Capitalized lease -Leases the equipment and makes payments on it -Purchasing it at the end of the lease. -Bargain price -Increase the value of the lease. -Have value until it expires or is exercised
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