FI 307 – United Inc.’s board has approved

FI 307 – United Inc.’s board has approved

Subject: Business    / Finance
Question

FI307 Leasing Mini Case Due Date: _March 26, _ Part A UNITED INC. and LIBERTY LEASING Team Submission United Inc.’s board has approved the manufacture and distribution of the high frequency
transmittor (HFT) the company has developed. To undertake this venture, the company needs to
obtain equipment for the production of the circuit board for the HFT. Because of the required
sensitivity of the circuit board and its delicate frame, the company needs specialized equipment
for production.
Barry Jones, the company president, has found a vendor for the equipment. Liberty Equipment
has offered to sell United Inc. the necessary equipment at a price of $4 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
$480,000.
Alternatively, the company can lease the equipment from Liberty Leasing. The lease contract
calls for four annual payments of $1,040,000, due at the beginning of the year. Additionally,
United Inc. must make a security deposit of $240,000 that will be returned when the lease
expires. United Inc. can issue bonds with a yield of 11 percent, and the company has a marginal
tax rate of 35 percent.
1 Should United Inc. buy or lease the equipment? (please show the schedule of cashflows
on a spreadsheet, separately for the buy option and the lease option, in support of your
answer). 1 Barry Jones mentions to Jerry Kelly, the president of Liberty Leasing, that although the
company will need the equipment for four years, he would like a lease contract for two
years instead. At the end of the two years, the lease could be renewed. Nick would also
like to eliminate the security deposit, but he would be willing to increase the lease
payments to $1,840,000 for each of the two years. When the lease is renewed in two
years, Liberty would consider the increased lease payments in the first two years when
calculating the terms of the renewal. The equipment is expected to have a market value of
$1.6 million in two years. What is the NAL of the lease contract under these terms? Why
might Barry prefer this lease? What are the potential ethical issues concerning the new
lease terms? 1 In the leasing discussion, Jerry Kelly informs Barry Jones that the contract could include
a purchase option for the equipment at the end of the lease. Liberty Leasing offers three
purchase options:
1 An option to purchase the equipment at the fair market value. 1 An option to purchase the equipment at a fixed price. The price will be negotiated
before the lease is signed.
1|Page 1 An option to purchase the equipment at a price of $200,000. How would the inclusion of a purchase option affect the value of the lease?
1 Jerry also informs Barry that the lease contract can include a cancellation option. The
cancellation option would allow United Inc. to cancel the lease on any anniversary date
of the contract. In order to cancel the lease, United Inc. 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? Part B Escalating steel costs have made Cable Corporation’s (“Cable”) Rewiring machine obsolete from
an economic point of view. Only two machines are available to replace it. The Wire Streaming
Machine (WSM) model is available only on a lease basis. The lease payments will be $65,000
for five years, due at the beginning of each year. This machine will save Cable $15,000 per year
through reductions in steel costs. As an alternative, Cable can purchase a more energy-efficient
machine from Taylor Equipment (TE) for $330,000. This machine will save $25,000 per year in
steel costs. A local bank has offered to finance the machine with a $330,000 loan. The interest
rate on the loan will be 10 percent on the remaining balance and will require five annual
principal payments of $66,000. Cable has a target debt-to-asset ratio of 67 percent. Cable is in
the 34 percent tax bracket. After five years, both machines will be worthless. The machines will
be depreciated on a straight-line basis.
1 Should Cable lease the WSM machine or purchase the more efficient TE machine? 1 Does your answer depend on the form of financing for direct purchase? 1 How much debt is displaced by this lease? 2 Show how this lease would be disclosed on the balance sheet and income statement of
Cable Corporation assuming it is classified as a “capital or financial” lease. 3 List the rules in Statement of Financial Accounting Standards No. 13 (FAS 13) and
identify, with reasons, whether it would be correct or incorrect to disclose this lease as a
capital lease. 4 Identify a listed company that utilizes capital leases, but also employs certain operating
leases, and summarize and explain the disclosure provided for both types of leases on
their financial statements (reference the source and date of the financials). The
explanation should explain what the numbers represent. If numbers are not identifiable on
the income statement, describe what charges would run through the income statement. (if
a company cannot be identified with both capital and operating leases, then describe how
an operating lease would be disclosed if it was in place. 2|Page