Mini Case: The Decision To Lease or Buy at Warf Computers

ACCT 3004: Finance II

Uyen Thi Phuong Pham - 101266481

Prof. Andrea Chance

Friday, November 12, 2021

 Question 1:

After-tax cost of debt = 0.11(1 – 0.35) = 0.0715

The present value of the CCA tax shield is:

PV of CCATS =

7,100,000×(0.45)(0.35) (1+ 0.5 ( 0.0715 )) 860,000(0.45)(0.35) 1

× − ×
0.0715+0.45 1+ 0.0715 0.0715+0.45 ( 1+ 0.0715) 4

= $1,875,711.36

The lost salvage value 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:

Year 0 Year 1 Year 2 Year 3 Year 4

Saved purchase $7,100,000

Lost salvage value -860,000

Lost dep. tax shield -1,875,711.36

Security deposit - 440,000 400,000

Lease payment -1,860,000 -1,860,000 -1,860,000 -1,860,000

Tax shield on lease 651,000 651,000 651,000 651,000

payment
Cash flow from leasing $3,575,288.6 $1,209,000 $1,209,000 $1,209,00 $460,000

4 0

And the NAL of the lease is:

NAL = $3,575,288.64 – $1,209,000/1.07151 – $1,209,000/1.07152 –

$1,209,000/1.07153 - $460,000/1.07154

NAL = $62,194.89

The company should lease the equipment.

Question 2:

The present value of the CCA tax shield now becomes:

PV of CCATS =

7,100,000×(0.45)(0.35) ( 1+ 0.5 ( 0.0715 )) 2,100,000(0.45)(0.35) 1

× − ×
0.0715+0.45 1+ 0.0715 0.0715+0.45 (1+ 0.0715)4

= $1,520,342.52

Year 0 Year 1 Year 2

Saved purchase $7,100,000
Lost salvage value -2,100,000
Lost dep. tax shield -1,520,342.52
 Lease payment -3,000,000 -3,000,000
Tax shield on lease 1,050,000 1,050,000

payment
Cash flow from leasing 3,629,657.48 -1,950,000 -2,100,000

So, the NAL is calculated as follows:

NAL = 3,629,657.48 - 1,950,000 /1.07151 - 2,100,000/1.07152

NAL = - 19,310.64

Going by the above calculations, the NAL of the lease is negative, so it might be

concluded that it is favorable to buy the equipment. However, the lease will now

be classified as an operating lease as the lease is for 2 years which is less than 75%

of the equipment life.

PV of the lease payment = 3,000,000 + 3,000,000/1.11 = $5,702,702.71

The present value of lease payments is less than 90% (7,100,000*90% =

$6,390,000) of the cost of equipment. If the lease contract enables the tenant to

acquire ownership at the end of the lease or as part of a bargain purchase, the lease

cannot be classified as a capital lease.

The capital lease does not include in the long-term liability, which makes the

balance look stronger and more verifiable. Therefore, the company can get more

investment or easier to issue stocks if it has, the market value of the company will

rise.

Therefore, changing the lease terms to make it appear an operating lease is not

ethical on Nick's part since the obligation would not be recorded on the balance

sheet.

Question 3:

a.

- The option does not provide the purchase price in advance.

- The lessor will not receive less than the equipment is worth.

- It has no effect on the value of the lease unless the lessor keeps the payments

low or avoid the equipment obsolescence.

b.
- It will increase the value of the lease.

- If we purchase equipment at the end of the lease at below market value, we

will save money.

- If we purchase at fixed price, we can purchase at the minimum value and

resell it in open market.

c. It would also be considered a call option if the lessee had the option to

purchase the equipment at a bargain price. It will result in an increase the

value of the lease. The contract condition in the lease will certainly ensure it

is a capitalized lease. Also, we need to make sure it has value until it

expired.

Question 4:

The cancellation option is also a real option in the hands of the lesser. Since the

lessee will only exercise the option when it is advantageous to the lessee, it will

increase the value of the lease.