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 $3.1 million in annual pretax cost savings. The system costs $7.9 million and will be depreciated straight-line to zero over 5 years. Wildcat's tax rate is 23 percent, and the firm can borrow at 7 percent. Lambert Leasing Company has offered to lease the drilling equipment to Wildcat for payments of $1.76 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

All amounts are in $

(a)

NAL = Net Advantage to Leasing

This is the excess benefits the firm obtains because of leasing an asset rather than purchasing it.

Savings in case asset is purchased

= Annual depreciation x Tax rate x Present value annuity factor @7% for 5 years

= (7.9 million/5) x 23% x 4.1001974

= 1,490,011.73516

Cost if asset is purchased = 7.9 million - 1,490,011.73516 = 6,409,988.26484

Cost of leasing = Annual lease payments (1 + present value Annuity factor @7% for 4 years) x (1-taxrate)

(The payments are made at start of year, so one is added to 4 years annuity)

= 1,760,000 x (1-23%) x (4.387211256)

= 5,945,548.6941

NAL = Cost if asset is purchased - Lease cost

= 6,409,988.26484 - 5,945,548.6941

= 464,439.57

(b)

In order to find the maximum acceptable lease payment, the difference between these two costs must be zero or both the costs must be same.

Let the lease payment be Y

Cost of purchase = Cost of lease

6,409,988.26484 = Y x (1-0.23) x (4.387211256)

Y = 6,409,988.26484/3.378152667

Y = 1,897,483.2983

So the maximum lease payment can be 1,897,483.30