Group F Module 7 Mini Case (1)

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Jan 9, 2024

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11/1/2023 Module 7 Mini Case Group F Sarah Deif Abdelshaheed Theodore Ibrahim Kassem Bazzi Huilin Shen Ke Yang

I NTRODUCTION Warf Computers is a company that can issue bonds with a yield of 11% and has a marginal tax rate of 35%. Warf Computers has decided to manufacture and distribute a new technology that involves a virtual keyboard. Operationally, Warf Computers requires specialized equipment to manufacture this sensitive technology, which can either be purchased or leased. If purchasing the equipment is to be pursued, Clapton Acoustical will sell at a price of $7.1 million, with a CCA rate of 45%, and a salvage value of $860,000 in four years. If the option to lease is to be pursued, Hendrix Leasing will charge four annual payments of $1.86 million due at the beginning of the year, as well as a security deposit which will be returned when the lease expires. This discussion will inform the decision around whether Warf Computers should purchase or lease the equipment, whether modifications to the lease agreement change the decision-making, associated ethical considerations, and purchase options at the end of a lease. Lastly, the impact of a cancellation option will be assessed.

D ISCUSSION P ART I: S HOULD W ARF BUY OR LEASE THE EQUIPMENT In order to determine if Warf should buy or lease the equipment, first the incremental cash flows need to be determined from leasing. The cash flows will need to be used to calculate the net advantage to leasing, according to the following: NAL = Investment – PV (after tax lease payments) – PVCCATS – PV (Salvage). Buy Year Initial Cost Beginning UCC CCCA Ending UCC Salvage After Tax Net Cash Flow 0 -7100000 -7100000 1 3550000 1597500 1952500 1952500 2 5502500 2476125 3026375 3026375 3 3026375 1361868.75 1664506.25 1664506.25 4 1664506.25 749027.8125 915478.4375 559000 1474478.438 NPV $ (696,359.91) After tax rate=0.11*(1-0.35)=0.0715 Lease Year Deposit Lease Payment After Tax Net Cash Flow 0 -440000 -440000 1 -1860000 -1860000 2 -1860000 -1860000 3 -1860000 -1860000 4 440000 -1860000 -1420000 NPV ($5,920,707.35) Therefore Warf should purchase the equipment because the NAL is negative.

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P ART II: L EASING THE CONTRACT FOR 2 YEARS INSTEAD , ELIMINATING THE SECURITY DEPOSIT , AND INCREASING LEASE PAYMENTS TO 3 MILLION . After Tax Salvage Value: 2100000 – (0.35*2100000) = 1365000 Year Deposit Lease Payment After Tax Saved Purchases Loss of Salvage Value Loss of Depreciation Tax Shield Net Cash Flow 0 0 -3000000 7100000 4100000 1 -3000000 -1952500 -4952500 2 -1365000 -3026375 -4391375 NPV ($4,346,890.75) $(5,858,837.23) NAL is still negative which would make it seem that it is favourable to purchase the equipment, despite these lease modifications. However, Nick may prefer this because the lease is now an operating lease at 2 years, given that the length of the lease does not make up the major part or more of the estimated economic life of the asset. The present value of the lease payments is =3000000+3000000/1.11 = $5702702.703 This is less than 90% of the cost of the equipment. Therefore this suggestion allows Nick to treat this as an operating lease as ownership will not be transferred and the present value of lease payments is not all of the fair market value of the asset at the start of the lease. This will allow Nick to keep this lease off of the statement of financial position, which would convey a stronger financial position than is true. This calls an ethical question into consideration as keeping this lease off the books would manipulate the appearance of the true financial position of the company, and is therefore unethical. This is also unethical in that it appears the changes to the lease agreement were made with the intention of treating this as an operating lease and keeping it off the books. P ART III: P URCHASE OPTIONS FOR THE EQUIPMENT AT THE END OF THE LEASE a) An option to purchase the equipment at the fair market value This option likely has no impact on the value of the lease, given that the company would be free to purchase equipment from anyone at a fair market price because this does not provide the purchase price in advance. The benefit is that the equipment will not be purchased for a price below market value which makes this beneficial only if the lease payments are low.

b) An option to purchase the equipment at a fixed price. The price will be negotiated before the lease is signed. This option will likely increase the value of the lease because presumably the price negotiated will be below market value. Whether the company chooses to keep the equipment for the fixed price, given that it is below market value, or chooses to resell it at market value, this agreement brings value to the lessee. As well, because ownership is transferred, this would be a financial lease. c) An option to purchase the equipment at a price of $275,000. This would increase the value of the lease because the equipment is being purchased at a price that is well below market value, so much so that it is a bargain. This lease becomes a financial lease because there is a purchase to be made at the end of the lease. P ART IV: C ANCELLATION O PTIONS The cancellation option would allow Warf Computers to cancel the lease on any anniversary date of the contract, with 30 days notice prior to the anniversary date. This would increase the value of the lease because this option would be utilized when there is an advantage to the lessee. This option would increase value until it expires or until the option is exercised. This also reduces risk of longer lease agreements because it is a lower commitment.

C ONCLUSION As discussed in the report above, if ethical decision-making remains a priority, Warf computers should purchase equipment rather than lease, as the NAL is negative for leasing equipment. However, the revised terms of the lease pose an ethical concern in that, despite a persistent negative NAL, the revised terms would constitute an operating lease which would eliminate its inclusion from the statement of financial position. However, revision of lease terms for the purposes of keeping it off the statement of financial position is an unethical practice. The value of the lease would be increased by a cancellation option, a fixed price purchase option, or a purchase price of $275,000 which is well below market value. Allowing for purchase at a fair market price has no impact on the value of the lease.

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