978-1259709685 Chapter 21 Case

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CHAPTER 21 CASE C-1

CHAPTER 21

THE DECISION TO LEASE OR BUY AT

WARF COMPUTERS

1. The decision to buy or lease is made by looking at the incremental cash flows. The incremental cash

flows from leasing the machine are the security deposit, the lease payments, the tax savings on the

lease, the lost depreciation tax shield, the saved purchase price of the machine, and the lost salvage

value. The salvage value of the equipment in four years will be:

This 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 $3,600,000

Lost salvage value –$286,000

The aftertax cost of debt is:

And the NAL of the lease is:

The company should lease the equipment.

2. The book value of the equipment in Year 2 will be:

CHAPTER 21 CASE C-2

So, the aftertax salvage value in Year 2 will be:

So, the NAL of the lease under the new terms would be:

Year 0 Year 1 Year 2

Saved purchase $3,600,000

Lost salvage value –$1,215,972

So, the NAL of the lease under these terms is:

The NAL of the lease is negative under these terms, so it appears the terms are less favorable for the

lessee. However, the lease will likely be classified as an operating lease. The lease is now for two

years, which is less than 75 percent of the equipment’s life. Using the company’s cost of debt, the

present value of the lease payments is:

This is less than 90 percent of the price of the equipment. As long as the lease contract does transfer

ownership to the lessee at the end of the contact, or allow for a purchase at a bargain price, the FAS

3. a. The inclusion of a right to purchase the equipment will have no effect on the value of the lease.

b. The right to purchase the equipment at a fixed price will have increase the value of the lease. If

the company can purchase the equipment at the end of the lease at below market value, it will

save money, or at a minimum, can purchase the equipment at the fixed price and resell it in the

CHAPTER 21 CASE C-3

c. The right to purchase the equipment at a bargain price is also a real option for the lessee, and

4. The cancellation option is also a real option. The cancellation option is a put option on the