Chapter 21, Problem 2MC

DECISION TO LEASE OR BUY AT WARF COMPUTERS

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 leas-e 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.

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?

Summary Introduction

To identify: Net advantage of lease under new terms, reason to prefer lease and ethical issues concerning new lease terms.

Leasing:

A contractual agreement between two persons to use the right of the property from one person to another is termed as leasing.

Explanation of Solution

Decision of lease or buy the system can be taken by evaluating the net advantage of leasing.

Given,

Cost of system is $3,600,000.

Calculated values,

After cost of debt rate is 0.0715.

Cash flows from leasing in year 1 are $1,631,900.

Cash flows from leasing in year 2 are $1,776,042.

Cost flow from buying is $2,527,500.

Formula to calculate net advantage of leasing,

$\text{Net}\text{advantage}\text{of}\text{leasing}=\left(\begin{array}{l}\text{Cash flow from buying}-\frac{\text{Cash flows from leasing}\text{in}\text{year}\text{1}}{{\left(1+\text{Rate}\right)}^1}\\ -\frac{\text{Cash flows from leasing}\text{in}\text{year}\text{2}}{{\left(1+\text{Rate}\right)}^2}\end{array}\right)$

Substitute $2,527,500 for cash flow from buying, $1,492,458 for cash flow from leasing in year 1, $1,776,042 for cash flow from leasing in year 2 and 0.0715 for rate.

$\begin{array}{c}\text{Net}\text{advantage}\text{of}\text{leasing}=\left(\$2,527,500-\frac{\$1,492,458}{{\left(1+0.0715\right)}^1}-\frac{\$1,776,042}{{\left(1+0.0715\right)}^2}\right)\\ =\left(\$2,527,500-\frac{\$1,492,458}{1.0715}-\frac{\$1,776,042}{1.1481}\right)\\ =\left(\$2,527,500-\$1,392,867.94-\$1,546,940.162\right)\\ =-\$412,308.102\end{array}$

• Net advantage of leasing under MACRS depreciation is $-\$412,308.102$. As net advantage of leasing is negative, one must buy the system.
• Net advantage of lease is negative and more negative with the new lease terms, therefore, buying is preferable
• Ethical issue concerning new lease terms is that, it is for short term, which might be done to avoid taxes.
• Lease contracts having high initial lease payments are considered as unethical, as it is done just to avoid tax over higher initial lease payments.

Working note:

Given,

Cost of system is $3,600,000.

MACRS depreciation rate for first year is 33.33% or 0.3333.

MACRS depreciation rate for second year is 44.45% or 0.4445.

Lease payment is $1,650,000 per year.

Tax rate is 35%.

Interest on borrowed amount is 11%.

Calculation of cash flow from buying,

$\begin{array}{c}\text{Cash flow from buying}=\text{Cost}\text{of}\text{asset}-\text{After}\text{tax}\text{lease}\text{payment}\\ =\$3,600,000-\$1,072,500\\ =\$2,527,500\end{array}$

First year,

Calculation of depreciation tax shield,

$\begin{array}{c}\text{Depreciation}\text{tax}\text{sheild}=\text{Cost}\text{of}\text{asset}\times \text{MACRS depreciation rate}\times \text{Tax}\text{rate}\\ =\$3,600,000\times 0.3333\times 0.35\\ =\$1,199,880\times 0.35\\ =\$419,958\end{array}$

Calculation of after tax lease payment,

$\begin{array}{c}\text{After}\text{tax}\text{lease}\text{payment}=\text{Annual}\text{Lease}\text{payment}\times \left(1-\text{Tax}\text{rate}\right)\\ =\$1,650,000\times \left(1-0.35\right)\\ =\$1,650,000\times 0.65\\ =\$1,072,500\end{array}$

Calculation of cash flows from leasing,

$\begin{array}{c}\text{Cash}\text{flow}\text{from}\text{leasing}=\text{Depreciation}\text{tax}\text{sheild}+\text{After}\text{tax}\text{lease}\text{payment}\\ =\$419,958+\$1,072,500\\ =\$1,492,458\end{array}$

Calculation of after tax cost of debt,

$\begin{array}{c}\text{After}\text{tax}\text{cost}\text{of}\text{debt}=\text{Cost}\text{of}\text{debt}\times \left(1-\text{Tax}\text{rate}\right)\\ =0.11\times \left(1-0.35\right)\\ =0.11\times 0.65\\ =0.0715\text{or}7.15\%\end{array}$

Second year,

Calculation of depreciation tax shield,

$\begin{array}{c}\text{Depreciation}\text{tax}\text{sheild}=\text{Cost}\text{of}\text{asset}\times \text{MACRS depreciation rate}\times \text{Tax}\text{rate}\\ =\$3,600,000\times 0.4445\times 0.35\\ =\$1,600,200\times 0.35\\ =\$560,070\end{array}$

Calculation of book value of asset,

$\begin{array}{c}\text{Book value of asset}=\left(\text{Cost}\text{of}\text{asset}-\left(\begin{array}{l}\text{Cost}\text{of}\text{asset}\\ \times \left(\begin{array}{l}\text{MACRS depreciation rate}\text{for}\text{year 1}\\ +\text{MACRS depreciation rate}\text{year 2}\end{array}\right)\end{array}\right)\right)\\ =\$3,600,000-\left(\$3,600,000\times \left(0.3333+0.4445\right)\right)\\ =\$3,600,000-\$2,800,080\\ =\$799,920\end{array}$

Calculation of after tax salvage value,

$\begin{array}{c}\text{After}\text{tax}\text{salvage}\text{value}=\text{Salvage}\text{value}-\left(\text{Tax}\text{rate}\times \left(\text{Salvage}\text{value}-\text{Book}\text{value}\right)\right)\\ =\$1,440,000-\left(0.35\times \left(\$1,440,000-\$799,920\right)\right)\\ =\$1,440,000-\$224,028\\ =\$1,215,972\end{array}$

Calculation of cash flows from leasing,

$\begin{array}{c}\text{Cash}\text{flow}\text{from}\text{leasing}=\text{Depreciation}\text{tax}\text{sheild}+\text{After}\text{tax}\text{salvage}\text{value}\\ =\$560,070+\$1,215,972\\ =\$1,776,042\end{array}$

Hence, net advantage of leasing is negative. Thus, buy decision is best but the new terms might be done to avoid taxes, which is unethical.