Chapter 21, Problem 4MC

DECISION TO LEASE OR BUY AT WARF COMPUTERS

Warf 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 keyboard. Because of the required sensitivity of the microphone and its small size, the company needs specialized equipment for production.

Nick Warf, the company president, has found a vendor for the equipment. Clapton Acoustical Equipment has offered to sell Warf Computers the necessary equipment at a price of $3.6 million. Because of the rapid development of new technology, the equipment falls in the three-year MACRS depreciation class. At the end of four years, the market value of the equipment is expected to be $440,000.

Alternatively, the company can lease the equipment from Hendrix Leasing. The leas-e contract calls for four annual payments of $935,000, due at the beginning of the year. Additionally,

Warf Computers must make a security deposit of $210,000 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.

4. James also informs Nick that the lease contract can include a cancellation option. The cancellation option would allow Warf Computers to cancel the lease on any anniversary date of the contract In order to cancel the lease, Warf Computers would be required to give 30 days’ notice prior to the anniversary date. How would the inclusion of a cancellation option affect the value of the lease?