Finance homework

Faisal1.xlsx

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1& 2

	Inputs:			Security deposit	210,000
	Cost of Equipment	3,600,000		Lease Payment	935,000
	Depreciable life (Years)	4		Tax rate	35.00%
	Salvage Value	440,000		Before-tax Cost of Debt	11.00%
	Outputs:
	After-tax Cost of Debt	7.15%
	Buy
	3- Years MACRs		33.33%	44.45%	14.81%	7.41%
	Depreciation Expense		1,199,880	1,600,200	533,160	266,760
	Depreciation Tax Shield		419,958	560,070	186,606	93,366
	Period	0	1	2	3	4
	Cash Flows	(3,600,000)	419,958	560,070	186,606	379,366
	NPV(buy)=	(2,280,761)
	Lease
	After-tax Lease Payment	607,750
	Period	0	1	2	3	4
	Cash Flows	(817,750)	(607,750)	(607,750)	(607,750)	210,000
	NPV(lease)=	(2,249,004)
	NPV( Lease minus Buy)	31,756
	Net Advantage to Leasing (NAL)	31,756
	Period	0	1	2	3	4
	Cash Flows ( Buy minus Lease)	2,782,250	(1,027,708)	(1,167,820)	(794,356)	(169,366)
	NPV( Lease minusBuy)	31,756
	Net Advantage to Leasing (NAL)	31,756
	It is profitable for the company to go for leasing option rather buying.
2	Book value of Equipment after 2 years	799,920
	Salvage value after 2 years	1,440,000
	Tax on Salvage value	224,028
	After-Tax Salvage Value in 2 Years	1,215,972
	Period	0	1	2
	Saved purchase cost of equipment	3,600,000
	Loss of salvage value			(1,215,972)
	Loss of depreciation Tax Shield		(419,958)	(560,070)
	Lease Payments	(1,650,000)	(1,650,000)
	Tax shield on Lease Payments	577,500	577,500
	Cash flow from Leasing	2,527,500	(1,492,458)	(1,776,042)
	NAL	(412,292)
	Going by the above calculations, it might be concluded that it is favorable to buy the equipment as NAL is negative. 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 economic life of the asset. Now, we will determine the present value of lease payments with use of company's cost of debt as follows:
	Present Value of Lease Payments = 1,650,000 + 1,650,000/(1+11%)^1 = $3,136,486.49
	The present value of lease payments is less than 90% (3,600,000*90% = $3,240,000) of the cost of equipment. In case, the lease contract allows for transfer of ownership to lesses at the termination of the contract or there is an option for bargain purchase, the lease cannot be treated as a capital lease (as per the relevant accounting standard requirements). Therefore, the suggestion to revise the lease terms in order to make it appear an an operating lease is not ethical on Nick's part as it would result in the lease obligation not getting reported in the balance sheet.

3

Analyzing the purchase option:

a) At the fair market value

- Buyer will not get the expected purchase value in advance

- The option will have no effect on the value of the lease

- The option can be used if an agreement is done to (1) keep payments low (2) avoid equipment obsolescence

b) To purchase at a fixed price:

The option might Increase the value of the lease; Purchasing equipment at the end the of the lease at below market value might result in saving money but it comes at a cost of used machine and of less economic value. Warf computer might also consider an option to purchase at the minimum value and then resell in the open market after the lease agreement expires.

c) Purchasing at a price of $250,000.

A Very high inclusion of payment in the NPV calculation; $250,000 at the end of 4 years will surely a bargain price considering the salvage value of similar machine to be $780,000.

4.

Cancellation option gives the Warf Computers the right to cancel the lease contract before the expiration period of 2 years (or before taking the next lease agreement in 2-year option). Under this condition, the equipment needs to be sent back to the owner and under such condition, the owner might consider the actual economic value of the product/technology at that point of time, which may result in increasing the lease contract value.