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 the 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 10% and the company has a marginal tax rate of 24%.

Required:

1. Should Warf buy or lease the equipment?

2. Nick mentions to James Hendrix, the president of Hendrix Leasing, that although the company will need the equipment for four years, he would like a lease contract of two years instead. At the end of the two years, the lease could be renewed. Nick also would like to eliminate the security deposit, but he would be willing to increase the lease payments to $1.875 million 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 renewal. The equipment is expected to have a market value of $3.2 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?

Additional info:

MACRS depreciation table is as follows:

Table 6.3 Depreciation under Modified Accelerated Cost Recovery System (MACRS) Recovery Period Class 3 Years 5 Years 7 Years 10 Years 15 Years 20 Years 1 .3333 .2000 .1429 .1000 .0500 .03750 Year 2 .4445 .3200 .2449 .1800 .0950 .07219 3 .1481 .1920 .1749 .1440 .0855 .06677 4 .0741 .1152 .1249 .1152 .0770 .06177 5 .1152 .0893 .0922 .0693 .05713 6 .0576 .0892 .0737 .0623 .05285 7 .0893 .0655 .0590 .04888 8 .0446 .0655 .0590 .04522 9 .0656 .0591 .04462 10 .0655 .0590 .04461 11 .0328 .0591 .04462 12 .0590 .04461 13 .0591 .04462 14 .0590 .04461 15 .0591 .04462 16 .0295 .04461 17 .04462 18 .04461 19 .04462 20 .04461 21 .02231 Table 6.3 Depreciation under Modified Accelerated Cost Recovery System (MACRS) Recovery Period Class 3 Years 5 Years 7 Years 10 Years 15 Years 20 Years 1 .3333 .2000 .1429 .1000 .0500 .03750 Year 2 .4445 .3200 .2449 .1800 .0950 .07219 3 .1481 .1920 .1749 .1440 .0855 .06677 4 .0741 .1152 .1249 .1152 .0770 .06177 5 .1152 .0893 .0922 .0693 .05713 6 .0576 .0892 .0737 .0623 .05285 7 .0893 .0655 .0590 .04888 8 .0446 .0655 .0590 .04522 9 .0656 .0591 .04462 10 .0655 .0590 .04461 11 .0328 .0591 .04462 12 .0590 .04461 13 .0591 .04462 14 .0590 .04461 15 .0591 .04462 16 .0295 .04461 17 .04462 18 .04461 19 .04462 20 .04461 21 .02231