Question

Case

Advanced 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 key board. Because of the

required sensitivity of the microphone and its small size, the company needs specialized

equipment for production.

Lucas Johnson, the company president, has found a vendor for the equipment. Memtech

Acoustical Equipment has offered to sell Advanced Computers the necessary equipment at a

price of $4.3 million. Because of the rapid development of new technology, the equipment will

be fully depreciated after four years with the straight line depreciation approach. At the end of

the fourth year, the market value of the equipment is expected to be $450,000.

Alternatively, the company can lease the equipment. Two leasing companies, Hendrix Leasing

and International Leasing Corporation, offered their leasing terms to Advanced Computers.

Hendrix proposed the following lease contract: The lease contract calls for monthly payment of

$90,000 due at the beginning of each month for four years. Additionally, Advanced Computers

must make a security deposit $200,000 at the beginning of the lease contract (i.e. at the

beginning of the first month) and the deposit will be returned when the lease expires at the end of

the last month.

International Leasing Corporation proposed the following lease contract: The lease contract calls

for monthly payment of $91,500 due at the beginning of each month for four years without

security deposit.

Advanced Computers can borrow a loan with the interest rate of 10% per year from a bank to

finance the equipment. The company has a marginal tax rate of 21%.

Questions:

1. Use Excel to calculate the net present values (NPVs) (it is also called net advantage to

leasing (NAL)) for Advanced Computers based on the lease contracts proposed by

Hendrix Leasing and International Leasing Corporation, respectively.

2. If the before-tax cost of debt of Hendrix Leasing is 4% per year and the marginal tax rate

is 21%, what is the net present value of the leasing contract for Hendrix Leasing? Use

Excel to do calculation.

3. If the before-tax cost of debt of International Leasing is 4.5% per year and the marginal

tax rate is 21%, what is the net present value of the leasing contract for International

Leasing? Use Excel to do calculation.

4. Write up a one-page memo to summarize the issue and your quantitative analysis. Based

on your analysis, please make recommendations about whether Advanced Computers

should buy or lease the equipment. If they decide to lease the equipment, which leasing

company should they choose and why? What are benefits brought by the leasing

contracts to Hendrix Leasing and International Leasing, respectively? You are supposed

to be a financial analyst in Advanced Computers and the memo is addressed to the

president Lucas Johnson

Answer 1

Given,

Equipment cost= $ 4.3 million ; Useful life of equipment= 4 years ; Market Value at 4th year=$450,000

Depreciation amount=$ 4.3 million/4 years (straight line depreciation)

=$ 1.075 million

Discount rate= Cost of borrowing=10% ; Tax rate=21%

Hendrix's lease terms-

monthy lease payment=$90,000 ($ 1.08 million yearly) ; Deposit=$200,000

Intl leasing corp's lease terms-

monthy lease payment=$91,500 ($ 1.098 million yearly) ; Deposit= NIL

Q1. Solution:

NPV (Net Advantage to leasing)= PV of owning - PV of leasing

PV of owning= Cost of equipment+PV of tax savings from depreciation+PV of resale value

tax savings per year =1.075 million * 21%=225,750

after tax resale value =355,500

PV of owning =-4,300,000+715,597.13+242,811.3= -3,341,592      (tax savings & resale value discounted @10%)

Therefore, NPV=3,341,592 - 2,740,249.437= $ 601,342.563

Therefore, NPV=3,341,592 - 2,749,604.685= $ 591,987.315