InnovativeComputers 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 key board. Because of the required sensitivity of the microphone and its small size, the company needs specialized equipment for production.
NickSmith, the company president, has found a vendor for the equipment.High QualityAcoustical Equipment has offered to sellInnovativeComputers the necessary equipment at a price of $5.3million. Because of the rapid development of new technology, the equipment falls in thethree-year MACRS depreciation class. At the end ofthefourthyear, the market value of the equipment is expected to be $450,000.
Alternatively, the company can lease the equipment. Two leasing companies,OxfordLeasing andKellerLeasing Corporation, offered their leasing terms toInnovativeComputers.Oxfordproposed the following lease contract: The lease contract calls forfourannual payments of $1.37million due at the beginning of the year. Additionally,InnovativeComputersmust make a security deposit $150,000 at the beginning ofthelease contract(i.e. at the beginning of Year 1)and the deposit will be returned when the lease expires at the end ofthefourthyear.
KellerLeasing Corporation proposed the following lease contract: The lease contract calls for fourannual payments of $1.38million due at the beginning of the year without security deposit.
InnovativeComputers can borrowaloan with the interest rate of 10% per year from a bank to financethe equipment. The company has a marginal tax rate of 21%.
Questions:
1.UseExcel to calculate thenet present values (NPVs) (it is also called net advantage to leasing (NAL))for Innovative Computers based on thelease contracts proposed byOxfordLeasing andKellerLeasing Corporation, respectively.
2.If the before-taxcost of debt of Oxford Leasing is 5% and the marginal tax rate is 21%, what is the net present value of the leasing contract for Oxford Leasing?Use Excel to do calculation.
3.If the before-tax cost of debt ofKeller Leasing is 5.5% and the marginal tax rate is 21%, what is the net present value of the leasing contract for Keller Leasing?Use Excel to do calculation.
4.Write up a one-page memo to summarize the issue and your quantitative analysis. Based on your analysis, please make recommendations about whetherInnovativeComputers should buy or lease the equipment. If they decide to lease the equipment, which leasing company should they choose and why?What are benefits brought by the leasing contracts to Oxford Leasing and Keller Leasing, respectively?You are supposed to be a financial analyst in Innovative Computers and the memo is addressed to the president Nick Smith.