You have just been hired as the new controller of SWT Services Inc., and on the top of the stack of papers on your new desk is a bundle of draft contracts with a note attached. The note says “please help me to understand which of these leases would be best for our situation.” The note is signed by the president of SWT Services Inc. You have reviewed the proposed contracts, and asked a few questions, and in the process have become aware that the company is facing a large cutback in capital spending to deal with the effect of competitive pressure in the industry. A new customer service system that is heavily IT based is critical in meeting the challenge head on. In order to meet this commitment, you need to identify the lease that will have the lowest total cost in the coming year and overall. As well you will need to address the cash demands of each choice. The leases are for telecommunications and computer equipment and software, and the following information is available.
Lease One: The equipment and software has a fair value of $487,694 and an expected life of six years. The lease has a five-year term. Annual rent is paid each January 1, beginning in 2011, in the amount of $104,300. The implicit rate of the lease is not known by SWT. Insurance and operating costs of $23,500 are to be paid directly by SWT to the lessor in addition to the lease payments. At the end of the lease term, the equipment will revert to the lessor, who will be able to sell it for $85,000. If the lessor is unable to sell the equipment for this amount, SWT will be required to make up the difference.
SWT will likely purchase the equipment for $85,000 if any payments are required under this clause of the lease.
Lease Two: The equipment and software have a fair value of $444,412 and an expected life of seven years. The lease has a five-year term beginning January 1, 2011, with a two-year renewal period. Annual lease payments are made beginning December 31, 2011, in the amount of $137,500. This lease has an implicit rate of 8%. Insurance and operating costs of $26,500 are included in the lease payment. At the end of the initial lease term, the equipment can be leased for another two years for $27,500 per year, including insurance and operating costs, and then at the end of that two-year period, the equipment will belong to SWT.
SWT uses private enterprise GAAP and has a December year end. SWT’s incremental borrowing rate is 10%
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Instructions
(a) Prepare a memo to the president explaining which lease will have the lowest cost in the initial year of the lease andoverall cost for the full term of the lease, including any renewal period for Lease Two. Include in your analysis a comparison of the cash flow requirement under each option for the term of the lease including any renewal option.
(b) Which lease do you recommend the company sign, assuming both will meet the company’s requirements and the equipment proposed in both leases is similar? Bring as many arguments to your recommendation as possible to allow the president to be fully advised of the factors leading to your recommendation.