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 $3.8 million in annual pretax cost savings. The system costs $8.8 million and will be depreciated straight-line to zero over 5 years. Wildcat's tax rate is 25 percent, and the firm can borrow at 8 percent. Lambert Leasing Company has offered to lease the drilling equipment to Wildcat for payments of $2.04 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

Solution:- Given in Question-

Cost of Machine = $8.8 Million

Useful Life = 5 years

Annual Depreciation =

Annual Depreciation =

Annual Depreciation = $1.76 Million.

Annual Tax shield on Depreciation = $1.76 Million * 25%

Annual Tax shield on Depreciation = $0.44 Million

NPV of the Machine = $8.8 Million - 0.44 Million * PVAF(8%, 5years)

NPV of the Machine = $8.8 Million - 0.44 Million * 3.9927

NPV of the Machine = $8.8 Million - $1.757 Million

NPV of the Machine = $7.043 Miilion

Post Tax Lease Payment = $2.04 Million (1 - 0.25)

Post Tax Lease Payment = $1.53 Million

Present Value of the lease Payment assuming all payments made at the beginning of the year-

Present Value = $1.53 + $1.53 * PVAF (8%, 5-1 years)

Present Value = $1.53 + $1.53 * 3.312

Present Value = $6.597 Million

A. Net Advantage Lease (NAL) for wildcat-

NAL = $7.043 - $6.597

NAL = $0.445 Million

B. Maximum lease payment that would be acceptable to the company-

Assume post tax lease payment = P, The NAL will be equal to zero.

0 = $7.043 Million - [P + P * PVAF (8%, 5year)]

$7.043 Million = 4.9927P

P = $1.41 Million

Pre Tax Lease Payment =

Pre Tax Lease Payment =

Pre Tax Lease Payment = $1.88 Million.

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