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 $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 Hendrix Leasing. The lease contract calls for four annual payments of $1,040,000, due at the beginning of the year. Additionally, Warf Computers must make a security deposit of $240,000 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.

1) Should Warf buy or lease the equipment?

2) NickmentionstoJamesHendrix,thepresidentofHendrixLeasing,thatalthough

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, Hendrix would consider the increased lease payments in the first two years when calculating the terms of the renewal.

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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 Nick prefer this lease? What are the potential ethical issues concerning the new lease terms?

3) In the leasing discussion, James informs Nick that the contract could include a purchase option for the equipment at the end of the lease. Hendrix Leasing offers three purchase options:

a. An option to purchase the equipment at the fair market value.

b. An option to purchase the equipment at a fixed price. The price will be negotiated before the lease is signed. An option to purchase the equipment at a price of $200,000.

c. How would the inclusion of a purchase option affect the value of the lease?

4) JamesalsoinformsNickthattheleasecontractcanincludeacancellationoption. The cancellation option would allow Warf Computers to cancel the lease on any anniversary date of the contract. In order to cancel the lease, Warf Computers 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?

Case II: Dividend and Financial Decision (8 points)

Electronic Timing, Inc. (ETI), is a small company founded 15 years ago by electronics engineers Tom Miller and Jessica Kerr. ETI manufactures integrated circuits to capitalize on the complex mixed-signal design technology and has recently entered the market for frequency timing generators, or silicon timing devices, which provide the timing signals or clocks necessary to synchronize electronic systems. Its clock products originally were used in PC video graphics applications, but the market subsequently expanded to include motherboards, PC peripheral devices, and other digital consumer electronics, such as digital television boxes and game consoles. ETI also designs and markets custom application specific integrated circuits (ASICs) for industrial customers. The ASICs design combines analog and digital, or mixed-signal, technology. In addition to Tom and Jessica, Nolan Pittman, who provided capital for the company, is the third primary owner. Each owns 25 percent of the $1 million shares outstanding. Several other individuals, including current employees, own the remaining company shares.

Recently, the company designed a new computer motherboard. The companys new design is both more efficient and less expensive to manufacture, and the ETI design is expected to become standard in many personal computers. After investigating the possibility of manufacturing the new motherboard, ETI determined that the costs involved in building a new plant would be prohibitive. The owners also decided that they were unwilling to bring in another large outside owner. Instead, ETI sold the design to an

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outside firm. The sale of the motherboard design was completed for an after tax payment of $30 million.

A. Tom believes the company should use the extra cash to pay a special one-time dividend. How will this proposal affect the stock price? How will it affect the value of the company?

B. Jessica believes that the company should use the extra cash to pay off debt and upgrade and expand its existing manufacturing capability. How would Jessicas proposals affect the company?

C. Nolan is in favor of a share repurchase. He argues that a repurchase will increase the companys P/E ratio, return on assets, and return on equity. Are his arguments correct? How will a share repurchase affect the value of the company?

D. Another option discussed by Tom, Jessica, and Nolan would be to begin a regular dividend payment to shareholders. How would you evaluate this proposal?

E. One way to value a share of stock is the dividend growth, or growing perpetuity, model. Consider the following: The dividend payout ratio is 1 minus b, where b is the retention or plowback ratio. So, the dividend next year will be the earnings next year, E 1 , times 1 minus the retention ratio. The most commonly used equation to calculate the sustainable growth rate is the return on equity times the retention ratio. Substituting these relationships into the dividend growth model, we get the following equation to calculate the price of a share of stock today:

What are the implications of this result in terms of whether the company should pay a dividend or upgrade and expand its manufacturing capability? Explain.

F. Does the question of whether the company should pay a dividend depend on