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 $2.6 million in annual pretax cost savings. The system costs $7.7 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 21 percent and the firm can borrow at 6 percent. Lambert Leasing Company has offered to lease the drilling equipment to Wildcat for payments of $1,660,000 per year. Lambert’s policy is to require its lessees to make payments at the start of the year. Suppose Lambert requires Wildcat to pay a $790,000 security deposit at the inception of the lease.

   

Calculate the NAL with the security deposit. (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

1. Lease or Buy: What is the NAL for Wildcat? What is the maximum lease payment that would be acceptable to the company?

First we calculate present value of the net cost of the machine

Cost of the machine = $7,700,000

Annual depreciation = $7,700,000/5 = $1,540,000

So, annual tax shield on depreciation = $1,540,000 * 21% = $323,400

So, net present value of the machine PV(Cost) = $7,700,000 - $323,400 * PVIFA(6%, 5 years)

= $7,700,000 - $323,400 * 4.2124

= $6,337,709.84

Post tax lease payment = $1,660,000 * (1 - 0.21) = $1,311,400

Present value of the lease payment (taking into consideration that all payments has been made at the beginning of each year)

PV (Lease) = $1,311,400 + $790,000 + $1,311,400 * PVIFA(6%, 4 years) - $790,000 * PVIF(6%, 5th year)

[here it is assumed that the security deposit will be received at the end of the lease term i.e. 5th year]

= $1,311,400 + $790,000 + $1,311,400 * 3.4651 - $790,000 * 0.7473

= $6,645,532.14 - $590,367

= $6,055,165.14

Net Advantage to Leasing (NAL) is the money saved from leasing an asset rather than buying it.

So, NAL (considering security deposit returned after the lease period) = $6,337,709.84 − $6,055,165.14

= $282,544.70

Hence, here cost of buying is more than the lease payment by $282,544.70.

So, NAL (not considering security deposit returned after the lease period) = $6,337,709.84 − $6,645,532.14

= ($307,822.30)

Hence, here cost of buying is less than the lease payment by $307,822.30.