Case

Background

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 treasurer, has found a vendor for the equipment. Clapton Acoustical Equipment has offered to sell Warf Computers the necessary equipment at a price of $4.3 million. Because of the rapid development of new technology, fully depreciated after four years (i.e., 48 months) with the straight-line depreciation approach. The depreciation expense incurs at the end of each month. At the end of four years, the market value of the equipment is expected to be $450,000.

Alternatively, the company can lease the equipment from Hendrix Leasing. The lease contract calls for monthly payment of $93,000 due at the beginning of each month for four years. Additionally, Warf Computers must make a security deposit of $200,000 at the beginning of the first month of the lease contract and the deposit will be returned when the lease expires at the end of the last month. Warf Computers can borrow a loan with an interest rate of 10% per year before taxes to finance the equipment. The company has a marginal tax rate of 21%. Make a recommendation whether Warf Computers should buy or lease the equipment.

In addition, Mr. Warf is planning to negotiate the lease terms with Hendrix Leasing to get a better deal. Only the monthly payment of the lease is negotiable and other terms cannot be negotiated. Hendrix Leasing can borrow a loan with an interest rate of 4% per year before taxes and its marginal tax rate is also 21%. Mr. Warf asked for a monthly payment that is lower than $93,000. However, the proposed monthly payment will make a net advantage to leasing for both Warf Computers and Hendrix Leasing positive.

Problem 1: Calculate net advantage to leasing for Warf Computers based on the lease contract proposed by Hendrix Leasing.

Problem 2: Calculate the monthly lease payment to make Net Advantage to leasing for Warf Computers breakeven and Hendrix Leasing breakeven and verify that Net Advantage to leasing's for both lessee and lessor are positive. Where Net Advantage to leasing = 0

Problem 3: Recommend a lease payment to help Mr. Warf negotiate a better deal with Hendrix Leasing.