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 $1.6 million in annual pretax cost savings. The system costs $9.1 million and will be depreciated straight-line to zero over its five-year life, after which it will be worthless. Wildcat's tax rate is 23 percent and the firm can borrow at 8 percent. Lambert Leasing Company has offered to lease the drilling equipment to Wildcat for payments of $2,030,000 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? (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 Wildcat? (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

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*23% = $0.4186 mln

So, net present value of the machine PV(C) = $9.1 mln - $0.4186 mln* PVIFA(8%, 5 years) = $9.1 mln - ($0.4186 mln* 3.9927) =$ 7.42865578 million

Post tax lease payment = $2.030 million*(1-23%) = $1.5631 million

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

PV(L)=$1.5631+$1.5631∗PVIFA(8%,4 years)

=$1.5631+$1.5631∗3.3121

=$6.74024351 million

So, NAL=$7.42865578mln−$6.74024351mln=$0.68841228 mln or $688,412.28

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

NAL=0= $7.42865578mln−[P+P∗PVIFA(8%, 5 years)

=> $7.42865578mln - P[1+ PVIFA(8%, 5years)]

Or, 4.9927∗P=$7.42865578 million

Or ,P=1.487903495million or 1,487,903.495

Pre-tax lease payment =1,487,903.495/0.77=$1, 932,342.201