Corporate Finance 

Warf Computers: Lease or Buy 

Case Study 
 

Submitted by: Submitted to: 

Sudan Khadgi Mr. Sanjay Ghimire 

18511, EMBA 2018 Faculty, KUSOM 
 

 
 
 

Q1. Should WARF lease or buy the equipment?

Calculation of Net Cash Outflow from Purchase of Equipment

Purchase Price of Equipment = $ 4,000,000

Salvage Value = $480,000

Security Deposit = $240,000

Lease Rental = $1,040,000

Calculation of PV of Net Cash Outflow from Purchase of Equipment

Yea PV of Cash
r Particulars Cash Flow PVF @ 7.15% Flow
-4,000,000.0
0 Initial Outflow 0 1 -4,000,000.00
1 Dep Tax Shield 466,620.00 0.933 435,482.97
2 Dep Tax Shield 622,300.00 0.871 542,020.17
3 Dep Tax Shield 207,340.00 0.813 168,541.39
4 Dep Tax Shield 103,740.00 0.759 78,700.51
4 Salvage Value 312,000.00 0.759 236,693.26
PV of Net
Outflow -2,538,561.70

Calculation of PV of Net Cash Outflow from Leasing of Equipment

Yea Security Lease Tax Net Cash PV of Cash
r Deposit Rental benefit Flow PVF @ 7.15% Flow
0 (240,000) (1,040,000) (1,280,000) 1 (1,280,000)
1 (1,040,000) 364,000 (676,000) 0.933 (630,891.27)
2 (1,040,000) 364,000 (676,000) 0.871 (588,792.60)
3 (1,040,000) 364,000 (676,000) 0.813 (549,503.13)
4 240,000 364,000 604,000 0.759 458,213.88
PV of Net Outflow -2,590,973.13

 
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The PV of Net Cash Outflow is lower while purchasing the equipment, it is better for the firm to
buy than lease the equipment.

Q2. 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 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. The equipment is expected to have a market value of $1.6 million in
two years. What is 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?

Calculation of PV of Outflow if Equipment is purchased in Year 3

Purchase Lease Tax Net Cash PV of Cash
Year Price/Salvage Value) Rental benefit Flow PVF @ 7.15% Flow
0 (1,840,000) (1,840,000) 1.000 (1,840,000)
(1,116,192.25
1 (1,840,000) 644,000 (1,196,000) 0.933 )
2 (1,600,000) 644,000 (956,000) 0.871 (832,671.20)
3 186,648 186,648 0.813 151,721.39
4 436,432.00 248,920 685,352 0.759 519,930.13
PV of Net
Outflow -3,117,211.93

Calculation of PV of Outflow if Equipment is leased in Year 3

Net Cash PV of Cash
Year Lease Rental Tax benefit Flow PVF @ 7.15% Flow
0 (1,840,000.00) (1,840,000.00) 1.000 (1,840,000.00)
1 (1,840,000.00) 644,000.00 (1,196,000.00) 0.933 (1,116,192.25)
2 (170,166.72) 644,000.00 473,833.28 0.871 412,706.40
3 (170,166.72) 59,558.35 59,558.35 0.813 48,413.46
4 59,558.35 59,558.35 0.759 45,182.89
PV of Net Outflow -2,449,889.50

 
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The Present Value of Net Cash Outflow in case the equipment is bought in Year 3: ​3,117,211.93

The Present Value of Net Cash Outflow in case the equipment is leased in Year 3: ​2,449,889.50

NAL of Lease Proposal:​ 667,322.43

The original lease term completes all criteria for the lease to be categorized as a capital lease, but
the revised proposal by Nick skews the criteria resulting in the lease being recognized as an
operating lease. This is also an ethical issue regarding the offer.

 
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Q3. 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.

c. 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?

a. The option to purchase the equipment at the fair market value at the end of the lease will have
no effect on the value of the lease because the equipment will be available to the lessee at the fair
market value at any point in time.

b. The option to purchase the equipment at a fixed prices increases the value of the lease if the
fixed price is below the fair market value. If the fixed price is below the fair market value, it
saves money to the lessee or provides the lessee an arbitrage opportunity where it can purchase
the equipment and sell it in the market.

c. Since the option to purchase is below the fair market value at the end of the lease, it will
increase the value of the lease.

 
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Q4. James also informs Nick that the lease contract can include a cancellation option. 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?

The cancellation option provided by the lessor will increase the value of the lease as it provides
an option to the lessee to cancel the lease at any point when the cancelation is advantageous for
the lessee.

 
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