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 $2.8 million in annual pretax cost savings. The system costs $9.5 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 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 $2,170,000 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

Net advantage to Leasing (NAL) = Present value of cost of buying the system - Present value of Cost of Leasing the System

Since the annual cost savings due to usage of new system will be indifferent (same) in both the situations i.e. buying of system as well leasing of system, the same may be ignored for the comparison/ NAL purpose.

Year	Capital Cost	Depreciation	Tax benefit on depreciation	Net Cash Flow	P.V. Factor @ 8%	P.V. of Net Cash Flow
[(capital cost 9500000-0 salvage value )/5 years]	[@ 25 %]	[1/(1+0.08)Year]	(Net Cash Flow*P.V. Factor)
0	(9,500,000)			(9,500,000)	1.0000	(9,500,000.00)
1	-	(1,900,000)	475,000	475,000	0.9259	439,802.50
2	-	(1,900,000)	475,000	475,000	0.8573	407,217.50
3	-	(1,900,000)	475,000	475,000	0.7938	377,055.00
4	-	(1,900,000)	475,000	475,000	0.7350	349,125.00
5	-	(1,900,000)	475,000	475,000	0.6806	323,285.00
Present value of cost of buying the system	(7,603,515.00)

Present value of cost of leasing the system
Year	Lease Payments (At start of year)	Tax benefit on lease payments (at end of year)	Net Cash Flow	P.V. Factor @ 8%	P.V. of Net Cash Flow
[@ 25 %]	[1/(1+0.08)Year]	(Net Cash Flow*P.V. Factor)
0	-2,170,000	0	-2,170,000	1.0000	(2,170,000.00)
1	-2,170,000	542,500	-1,627,500	0.9259	(1,506,902.25)
2	-2,170,000	542,500	-1,627,500	0.8573	(1,395,255.75)
3	-2,170,000	542,500	-1,627,500	0.7938	(1,291,909.50)
4	-2,170,000	542,500	-1,627,500	0.7350	(1,196,212.50)
5	0	542,500	542,500	0.6806	369,225.50
Present value of cost of leasing the system	(7,191,054.50)

Net advantage to Leasing (NAL) = Present value of cost of buying the system - Present value of Cost of Leasing the System

Net advantage to Leasing (NAL) = 7603515 - 7191054.50

Net advantage to Leasing (NAL) = 412460.50

Maximum lease payment that would be acceptable to Wildcat, will be the payment at which the NAL will be zero i.e. where the PV of Cost of leasing the system is equal to PV of cost of buying the system.

Therefore where lease payment is L, the present value of Leasing the system will be:

Present value of cost of leasing the system
Year	Remarks	Lease Payments	Tax benefit on lease payments (at end of year)	Net Cash Flow	P.V. Factor @ 8%	P.V. of Net Cash Flow
[@ 25 %]	[1/(1+0.08)Year]	(Net Cash Flow*P.V. Factor)
0		-L		-L	1.0000	-L
1		-L	0.25L	-0.75 L	0.9259	-0.694425L
2		-L	0.25L	-0.75 L	0.8573	-0.642975L
3		-L	0.25L	-0.75 L	0.7938	-0.59535L
4		-L	0.25L	-0.75 L	0.7350	-0.55125L
5			0.25L	0.25 L	0.6806	0.17015L
Present value of cost of leasing the system		-3.31385L

Therefore, Maximum lease payment that would be acceptable to Wildcat where PV of cost of leasing of system = PV of cost of buying of system

or say 3.31385L = 7603515

or say L = 7603515/3.31385

or say L = 2,294,466