CHAPTER 27

THE DECISION TO LEASE OR BUY AT WARF COMPUTERS

1.
The decision to buy or lease is made by looking at the incremental cash flows.
The incremental cash flows from leasing the machine are the security deposit,
the lease payments, the tax savings on the lease, the lost depreciation tax
shield, the saved purchase price of the machine, and the lost salvage value. The
salvage value of the equipment in four years will be:
Aftertax salvage value = $600,000 $600,000(.35) Aftertax salvage value =
$390,000
This is an opportunity cost to Warf Computers since if the company leases the
equipment it will not be able to sell the equipment in four years. The lease
payments are due at the beginning of each year, so the incremental cash flows
are:
Saved purchase Lost salvage value Lost dep. tax shield Security deposit Lease
payment
Tax on lease payment Cash flow from leasing
$5,000,000
$583,275 $777,875 $259,175
300,000 1,300,000 1,300,000 1,300,000 1,300,000 455,000 455,000
455,000 455,000 $3,855,000 $1,428,275 $1,622,875 $1,104,175
$390,000 129,675 300,000
$219,675
The aftertax cost of debt is:
Aftertax cost of debt = .11(1 .35) Aftertax cost of debt = .0715 or 7.15% And
the NAL of the lease is:
NAL = $3,855,000 $1,428,275/1.0715 $1,622,875/1.07152
$1,104,175/1.07153 $219,675/1.07154 NAL = $44,308.0
The company should lease the equipment.
C-72 CASE SOLUTIONS 2.
The book value of the equipment in year 2 will be: Book value = $5,000,000
$5,000,000(.3333 + .4445) Book value = $1,111,000
So, the aftertax salvage value in year 2 will be:
Aftertax salvage value = $2,000,000 + ($1,111,000 2,000,000)(.35) Aftertax
salvage value = $1,688,850
So, the NAL of the lease under the new terms would be:
Saved purchase Lost salvage value Lost dep. tax shield Lease payment

Tax on lease payment Cash flow from leasing

$5,000,000
$1,688,850 $583,275 777,875
2,300,000 2,300,000 805,000 805,000 $3,505,000 $2,078,275 $2,466,725
So, the NAL of the lease under these terms is:
NAL = $3,805,000 $2,078,275/1.0715 $2,466,725/1.07152 NAL =
$583,099.11
The NAL of the lease is negative under these terms, so it appears the terms are
less favorable for the lessee. However, the lease will likely be classified as an
operating lease. The lease is now for two years, which is less than 75 percent of
the equipments life according. Using the companys cost of debt, the present
value of the lease payments is: PV of lease payments = $2,300,000 +
$2,300,000/1.11 PV of lease payments = $4,372,072.07
This is less than 90 percent of the price of the equipment. As long as the lease
contract does transfer ownership to the lessee at the end of the contact, or allow
for a purchase at a bargain price, the FAS 13 conditions for a capital lease are not
met. As such, the reason for suggesting the revised lease terms is unethical on
Nicks part. Also, notice that the question also states that if the lease is renewed
in two years, the lessor will allow for the increased lease payments made over
the first two years. This is also an indication that the revision is for less than
ethical reasons.
CHAPTER 27 C-73
3. a.
The inclusion of a right to purchase the equipment will have no effect on the
value of the lease. If the company does not purchase the equipment, it can go on
the market and purchase identical equipment at the same price.
The right to purchase the equipment at a fixed price will increase the value of
the lease. If the company can purchase the equipment at the end of the lease at
below market value, it will save money, or at a minimum, can purchase the
equipment at the fixed price and resell it in the open market. This is a real
option, therefore has value to the lessee. It is a call option on the equipment. As
such, it must have a value until it expires or is exercised. It is also important to
note that this would likely make the lease contract a capitalized lease.
The right to purchase the equipment at a bargain price is also a real option for
the lessee, and will increase the value of the lease. It is a call option, and
therefore will have value until it expires or is exercised. This contract condition
will definitely ensure the lease is classified as a capitalized lease.
b.
c.
4.

The cancellation option is also a real option. The cancellation option is a put
option on the equipment. It will increase the value of the lease since the lessee
will only exercise the option when it is to the lessees advantage.