Question

The Wildcat Oil Company is trying to decide whether to lease or buy a new computer-assisted drilling system for its oil exploration business. Management has decided that it must use the system to stay competitive; it will provide $4.1 million in annual pretax cost savings. The system costs $9.1 million and will be depreciated straight-line to zero over 5 years. Wildcat's tax rate is 22 percent, and the firm can borrow at 8 percent. Lambert Leasing Company has offered to lease the drilling equipment to Wildcat for payments of $2.12 million per year. Lambert's policy is to require its lessees to make payments at the start of the year.

What is the NAL for Wildcat? (A negative answer should be indicated by a minus sign. Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to 2 decimal places, e.g., 1,234,567.89.)

What is the maximum lease payment that would be acceptable to the company? (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to 2 decimal places, e.g., 1,234,567.89.)

Answer is complete but not entirely correct.

	a. NAL $-0.04   selected answer incorrect b. Maximum lease payment $2,110,328.00 selected answer incorrect

Answer 1

First we calculate present value of the net cost of the machine

Cost of the machine = $9.1 mln

Annual depreciation = $9.1 mln/5 = $1.82 mln

So, annual tax shield on depreciation = $1.82 mln*22% = $0.4004 mln

So, net present value of the machine PV(C) = $9.1 mln - $0.4004 mln* PVIFA(8%, 5 years) = $9.1 mln - $0.4004 mln* 3.9927 =$ 7.50 million

Post tax lease payment = $2.12 million*(1-22%) = $1.6536 million

Present value of the lease payment (assuming all the payments has been made at the beginning of each year)

PV(L)=$1.42+$1.42∗PVIFA(9%,4 years)PV(L)=$1.6536+$1.6536∗PVIFA(8%,4 years)

=$1.6536+$1.6536∗3.3121 = $7.13 milion

So, NAL=Net present value of machine - present value of payments

= $7.50-7.13 = $0.37million

For maximum lease payment, the NAL will be equal to zero (assuming post tax lease payment = P)

NAL = 0 = $7.50mln -(P+P*PVIFA(8%,5years))

0=7.5 - P(1+3.9927)

7.5million = P(4.9927)

P = $1.50 million

Pre-tax lease payment =1.50 million/0.78=$1.92 million