MINICASETHE 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 $6.1 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 $780,000.

Alternatively, the company can lease the equipment from Hendrix Leasing. The lease contract calls for four annual payments of $1.48 million due at the beginning of the year. Additionally, Warf Computers must make a security deposit of $400,000 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 21percent.

QUESTION

1. Should Warf buy or lease the equipment?

Purchase $6,100,000

End of 4 yrs MV $780,000

Aftertax Salvage Value 616200

Lease PMT $1,480,000

Security $400,000

bonds 11%

tax 21%

Discount Rate or aftertax cost of debt 8.69%

Year 0 Year 1 Year 2 Year 3 Year 4

Saved Purchase $6,100,000

Lost salvage value ($616,200)

Lost dep. Tax shield $(320,250) $(320,250) $(320,250) $(320,250)

Security Deposit $(400,000) $400,000

Lease Payment $(1,480,000) $(1,480,000) $(1,480,000) $(1,480,000)

Tax on Lease Payment $310,800 $310,800 $310,800 $310,800

Total Cash Flow $4,530,800 $(1,489,450) $(1,489,450) $(1,489,450) $(536,450)

PLEASE VERIFY MY CALCULATIONS, if incorrect, please explain. I think my MACRS depreciation calculation may be incorrect. Please provide those calculations.

Net Advantage to Leasing or NPV $355,246.40