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.

a.	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.)
b.	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 1

	Answer
a	Purchase asset
	System Cost	$      9,100,000.00
	Pre tax cost savings	$      4,100,000.00
	Life of system	5 years
	Depreciation	Cost /Life
		$      1,820,000.00
	Pre tax cost savings	$      4,100,000.00
	Less : Depreciation	$      1,820,000.00
	Pre tax cost savings	$      2,280,000.00
	tax @ 22%	$         501,600.00
	Post tax savings	$      1,778,400.00
	Add : Depreciation	$      1,820,000.00
	Net cash flows	$     3,598,400.00
	Discount rate	8%
	Presnet value of cash flows	PVAF(8%,5years)*3598400
	PVAF(6%,5years)	1-(1+r)^-n/r
		(1-(1.08)^-5)/0.08
		3.9927
	Presnet value of cash flows	$   14,367,367.80
	Asset on Lease
	Pre tax cost savings	$      4,100,000.00
	Lease Payment	$      2,120,000.00
		$      1,980,000.00
	Tax @ 22%	$         435,600.00
	Net cash flows	$      1,544,400.00
	Present Value of Cash Flows	$     6,166,341.38
	NAL of Wildcat	$   (8,201,026.42)
b	Maximum Lease Payment acceptable to wildcat
	In order to accept the lease proposal the cash flows under both options should be equal
	Or Else it should be less than cash flows under purchase option.
	Pre tax cost savings	$      4,100,000.00
	Lease Payment	X
		4100000-X
	Tax @ 22%	(4100000-X)*22%
	Net cash flows	(4100000-X)*78%
	Net cash flows should be equal to	$      3,598,400.00
	(4100000-X)^78%	$      3,598,400.00
	(4100000-X)	$      4,613,333.33
	X	4613333.33-4100000
	Lease payment should be equal to	$         513,333.33