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FI307 Leasing Mini Case Due Date: _March 26, _ Part A UNITED INC. and LIBERTY LEASING Team Submission United Inc.'s board has approved the manufacture and distribution of the high frequency transmittor (HFT) the company has developed. To undertake this venture, the company needs to obtain equipment for the production of the circuit board for the HFT. Because of the required sensitivity of the circuit board and its delicate frame, the company needs specialized equipment for production. Barry Jones, the company president, has found a vendor for the equipment. Liberty Equipment has offered to sell United Inc. 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 Liberty Leasing. The lease contract calls for four annual payments of $1,040,000, due at the beginning of the year. Additionally, United Inc. must make a security deposit of $240,000 that will be returned when the lease expires. United Inc. can issue bonds with a yield of 11 percent, and the company has a marginal tax rate of 35 percent. 1 Should United Inc. buy or lease the equipment? (please show the schedule of cashflows on a spreadsheet, separately for the buy option and the lease option, in support of your answer). 1 Barry Jones mentions to Jerry Kelly, the president of Liberty 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, Liberty 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 Barry prefer this lease? What are the potential ethical issues concerning the new lease terms? 1 In the leasing discussion, Jerry Kelly informs Barry Jones that the contract could include a purchase option for the equipment at the end of the lease. Liberty Leasing offers three purchase options: 1 An option to purchase the equipment at the fair market value. 1 An option to purchase the equipment at a fixed price. The price will be negotiated before the lease is signed. 1|Page 1 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? 1 Jerry also informs Barry that the lease contract can include a cancellation option. The cancellation option would allow United Inc. to cancel the lease on any anniversary date of the contract. In order to cancel the lease, United Inc. 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? Part B Escalating steel costs have made Cable Corporation's (\"Cable\") Rewiring machine obsolete from an economic point of view. Only two machines are available to replace it. The Wire Streaming Machine (WSM) model is available only on a lease basis. The lease payments will be $65,000 for five years, due at the beginning of each year. This machine will save Cable $15,000 per year through reductions in steel costs. As an alternative, Cable can purchase a more energy-efficient machine from Taylor Equipment (TE) for $330,000. This machine will save $25,000 per year in steel costs. A local bank has offered to finance the machine with a $330,000 loan. The interest rate on the loan will be 10 percent on the remaining balance and will require five annual principal payments of $66,000. Cable has a target debt-to-asset ratio of 67 percent. Cable is in the 34 percent tax bracket. After five years, both machines will be worthless. The machines will be depreciated on a straight-line basis. 1 Should Cable lease the WSM machine or purchase the more efficient TE machine? 1 Does your answer depend on the form of financing for direct purchase? 1 How much debt is displaced by this lease? 2 Show how this lease would be disclosed on the balance sheet and income statement of Cable Corporation assuming it is classified as a \"capital or financial\" lease. 3 List the rules in Statement of Financial Accounting Standards No. 13 (FAS 13) and identify, with reasons, whether it would be correct or incorrect to disclose this lease as a capital lease. 4 Identify a listed company that utilizes capital leases, but also employs certain operating leases, and summarize and explain the disclosure provided for both types of leases on their financial statements (reference the source and date of the financials). The explanation should explain what the numbers represent. If numbers are not identifiable on the income statement, describe what charges would run through the income statement. (if a company cannot be identified with both capital and operating leases, then describe how an operating lease would be disclosed if it was in place. 2|Page