Smith 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 key board. Because of the required sensitivity of the microphone and its small size, the company needs specialized equipment for production.
Nick Smith, the company president, has found a vendor for the equipment. Clapton Acoustical Equipment has offered to sell Smith Computers the necessary equipment at a price of $7.5 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 $700,000.
Alternatively, the company can lease the equipment. Two leasing companies, Hendrix Leasing and International Leasing Corporation, offered their leasing terms to Smith Computers. Hendrix proposed the following lease contract: The lease contract calls for four annual payments of $1.65 million due at the beginning of the year. Additionally, Smith Computers must make a security deposit $500,000 at the beginning of lease contract and the deposit will be returned when the lease expires at the end of the fourth year.
International Leasing Corporation proposed the following lease contract: The lease contract calls for four annual payments of $1.66 million due at the beginning of the year without security deposit.
Smith Computers can borrow an amortizing loan with the interest rate of 10% per year from a bank to finance the equipment. The company has a marginal tax rate of 40%.
Questions:
1. Use the Excel to calculate the net present value (NPV) of the relevant cash flows if Smith Computers borrow and buy the equipment.
2. Use the Excel to calculate the net advantage to leasing (NAL) for lease contracts proposed by Hendrix Leasing and International Leasing Corporation, respectively. Net advantage to leasing is calculated as the net present value of the after-tax lease cash flows.