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 lease contract (i.e., at the beginning of the first month) 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%. A financial analyst who is working for Mr. Warf was asked to make an analysis and then make a recommendation to him 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. Suppose that 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 the analyst to recommend a monthly payment that is lower than $93,000. However, the proposed monthly payment will make a net advantage to leasing (NAL) for both Warf Computers and Hendrix Leasing positive.

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

Problem 2: Calculate the monthly lease payment to make NAL for Warf Computers breakeven and Hendrix Leasing breakeven, i.e., NAL=0

Problem 3: After the range of the monthly lease payment that may make NAL for Warf Computers and Hendrix Leasing positive has been figured, recommend a lease payment to help Mr. Warf negotiate a better deal with Hendrix Leasing.

Problem 4: Calculate NAL for Warf Computers and Hendrix Leasing based on the monthly lease payment recommended to verify that NALs for both lessee and lessor are positive.