Financial Decision Making problem set

Ryan, the president of the Open Corporation, is considering leasing or purchasing equipment.
Microtech Corporation has offered to sell the Open Corporation the equipment at a price of
$6010,000. Following its usual practice, the equipment is depreciated over four years, at the rates
of 40% for the first year, and 20% for each of the remaining three years. The salvage value of this
equipment is expected to be 0.
Alternatively, the Open Corporation can lease the equipment from Scott Corporation. Four annual
lease payments of $1.9 million are settled at the beginning of each year. Open Corporation can
raise capital by issuing bonds with a yield of 12 percent, and the tax rate for Open Corporation is
set to be 30 percent.
After comparing the above two options, the Chief Financial Officer of Open Corporation,
commented, “Scott’s offer is financially unreasonable due to a negative NAL (i.e. net advantage
to leasing) to our company. Therefore, the annual lease payments should be curtailed. Meanwhile,
we can pay a security deposit to Scott as an incentive. This deposit would be returned on the
expiration date of the lease contract.” In response to CFO’s comments, Ryan added, “If the leasing
term is acceptable to us, this will suggest that a negative NAL should be brought to Scott. As far
as I know, leasing is a zero-sum game between the lessee and lessor. I believe Scott reject our
counter offer.” After several rounds of discussion, Ryan eventually determines to propose a
counter offer to Scott, with a reduced lease payment of $1.8 million on annual basis and a security
deposit of $1,000,000.
(a) In light of the NAL calculation, comment on the following remarks “Scott’s
offer is financially unreasonable due to a negative NAL (i.e. net advantage to
leasing) to our company.” (12 marks)
(b) According to the counter offer by the Open Corporation, evaluate the NAL
to Scott. What is the reaction of Scott to this counter offer? The tax rate for
Scott is presumed to be 40%. (14 marks)
(c) Critically discuss Ryan’s remark “leasing is a zero sum game between the
lessee and lessor”. (12 marks)
(d) Explain the rationale for lessees to accept a lease offer even if NALs are
negative. (12 marks)
(e) If the purchase of equipment is funded by bond issuance instead of own
capital, do you consider this factor in NAL analysis? Explain.

Sample Solution