International Computer Company ( ICC) has annual revenues of $ 2 billion primarily from selling and leasing large networked workstation systems to businesses and universities. The manufacturing division produces the hardware that is sold or leased by the marketing division. After the expiration of the lease, leased equipment is returned to ICC, where it is either disassembled for parts by the field service organization or sold by the international division. Internal studies have shown that equipment leased for four years is worth 36 2/ 3 percent of its original manufacturing cost as parts or sold over-seas. About half of ICC’s systems are leased and half are sold, but the fraction being leased by ICC is a falling proportion of total sales.

The leasing department is evaluated on profits. Its annual profits are based on the present value of the lease payments from new leases signed during the year, less

1. The unit manufacturing cost of the equipment.

2. Direct selling, shipping, and installation costs.

3. The present value of the service agreement costs.

Each leased piece of equipment will be serviced over its life by ICC’s field service organization. The leasing division arranges a service contract for each piece of leased equipment from the field service organization. The field service organization commits to servicing the leased equipment at a fixed annual cost, determined at the time the lease is signed.

The leasing department then builds the service cost into the annual lease payment. The leasing department negotiates the lease terms individually for each customer. In general, the leasing division sets the annual lease terms to recover all three cost components plus a 25 percent markup (before taxes). The 25 percent markup for setting the annual lease payment seemed to work well in the past and provided the firm with a reasonable return on its investment when ICC had dominance in the workstation market niche. However, in recent years new entrants have forced the ICC leasing department to reduce its markup to as low as 10 percent to sign leases. At this small margin, senior management is considering getting out of the lease business and just selling the systems. The following lease to Gene Science is being priced by the leasing department. A four-year lease of a small network of three workstations is being negotiated. The unit manufacturing cost of the network is $ 30,000. The service costs, which are payable to the field service department at the beginning of each year, are $ 2,000 (payable at installation), $ 3,000, $ 4,000, and $ 5,000 ( payable at the beginning of each of the next three years, respectively). Selling, shipping, and installation costs are $ 7,000. The leasing department has an 8 percent cost of capital.

To simplify the analysis, ignore all tax considerations.

Required:

a. Using a 25 percent markup on costs and an 8 percent discount rate, calculate the fixed annual lease payment for the four- year lease to Gene Science.

b. Comment on some likely reasons why a 25 percent markup on leased equipment is proving more difficult to sustain. Should ICC abandon the lease market? What are some alternative courses of action?