Question

Nick from Warf Computers company would like to lease equipment equipment from Hendrix Leasing. The lease contract calls for four annual payments of $1,040,000, due at the beginning of the year. Additionally, Warf Computers must make a security deposit of $240,000 that will be returned when the lease expires. Warf Computers can issue bonds with a yield of 11 percent, and the company has a marginal tax rate of 35 percent.

After thought, Nick says 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 the NAL of the lease contract under these terms?

Answer 1

In this question we will evaluate the two leasing options by calculating the NPV of the two options.

Cost of capital of the company = i(1- tax rate) where i is the interest rate

Hence cost of capital = 11%(1-35%) = 7.15%

Option 1

In this option the PV of outflows is $ 36,24,665 as calculated below:

Option 1
Time	Deposit	Lease Payments	Total Cashflow	PV @ 7.15%
Y0	2,40,000	10,40,000	12,80,000	12,80,000
Y1		10,40,000	10,40,000	9,70,602
Y2		10,40,000	10,40,000	9,05,835
Y3		10,40,000	8,00,000	6,50,300
Y4	-2,40,000	0	-2,40,000	-1,82,072
Total				36,24,665

Option 2

In this option PV of outflows is $ 49,50,811 as calculated below:

Option 2
Time	Lease Payments	PV @ 7.15%
Y0	18,40,000	18,40,000
Y1	18,40,000	17,17,219
Y2	16,00,000	13,93,592
Y3		0
Y4	0	0
Total		49,50,811

Net Advantage of Leasing:

Cost of option 2 - Cost of option 1

= 4950811-3624665

=$ 1326146