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

a) Computation of NAL

Computation of Net Present value of Buying the Machine

Year	Annual Pre Tax Cost savings( In million $ )	Tax @ 22%	After Tax savings	Depreciation	Annual Cash flow	Disc @ 8%	Discounted Cash flows
1	$4.10	$0.90	$3.20	$1.82	$5.02	0.9259	$4.65
2	$4.10	$0.90	$3.20	$1.82	$5.02	0.8573	$4.30
3	$4.10	$0.90	$3.20	$1.82	$5.02	0.7938	$3.98
4	$4.10	$0.90	$3.20	$1.82	$5.02	0.7350	$3.69
5	$4.10	$0.90	$3.20	$1.82	$5.02	0.6806	$3.42
							$20.04

Computation of Net Present value

We know that NPV = Present value of Cash inflows- PV of Cash outlay

= $ 20.04-$ 9.1

= $ 10.94 Millions

Computation of Present value of Cost of lease payments

Year	Amount( $ Millions)	Disc @ 8%	Discounted Cash flows
1	$2.12	1	$2.12
2	$2.12	0.925926	$1.96
3	$2.12	0.857339	$1.82
4	$2.12	0.793832	$1.68
5	$2.12	0.73503	$1.56
			$9.14

We know that NPV = Present value of Cash inflows- PV of Cash outlay

= $ 20.04-$ 9.14

= $ 10.9 Millions

Net Advantage to leasing = NPV of leasing - NPV of Buying a Machine'

= 10.9 Millions-$ 10.94 Millions

= -$ 0.04 Millions

Hence NAL is -$ 0.04 Millions

Hence there is no Advantage in leasing. If we lease the machine NPV gets lower by$ 40000 when Compared to buying the Machine

b) The Maximum Lease paymennt that would be acceptable to the Company

For Buying the Machiine our cash outlay is $ 9.1 Millions

For leasing also we can afford for $ 9.1 Millions in Present value terms

Let the Annual lease payment is X

Year	Amount( $ Millions)	Disc @ 8%
1	X	1
2	X	0.925926
3	X	0.857339
4	X	0.793832
5	X	0.73503
		4.312127

We know that the Present value of the future cash outflows should be equal to the $ 9.1 Millions'

X * 4.312127 = $ 9.1 Millions

X = $ 9.1/ 4.312127 Millions

X = 2.110328 Millions

Hence the Maximum lease payment that Copany can afford is $ 21,10328.

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