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 $1.8 million in annual pretax cost savings. The system costs $9.3 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 6 percent. Lambert Leasing Company has offered to lease the drilling equipment to Wildcat for payments of $2,086,667 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

Solution:-

First we need to calculate after tax cost of Bond-

Cost of Bond after tax = 6% (1-0.25)

Cost of Bond after tax = 4.50%

After tax lease payment is = $20,86,667 (1-0.25)

After tax lease payment is =$15,65,000

Depreciation Tax shield loss =

Depreciation Tax shield loss =

Depreciation Tax shield loss = $4,65,000

To Calculate NAL-

NAL = Initial Cost - After tax lease payment - After tax lease payment * PVAF(4.50%, 4) - Depreciation tax shield loss * PVAF (4.50% , 5)

NAL = $93,00,000 - $15,65,000 - $15,65,000 * 3.587526 - $4,65,000 * 4.3899767

NAL = $93,00,000 - $15,65,000 - $56,14,477.72 - $20,41,339.19

NAL = $79,183.09

The Equipment should be leased.

To Find Maximum Lease payment, at NAL is equal to zero.

Let Maximum Payment is X

0 = $93,00,000 - X(1.045) * PVAF (4.50%, 5) - $4,65,000 * PVAF (4.50%, 5)

0 = $93,00,000 - X(1.045)(4.3899767) - $20,41,339.19

$72,58,660.81 =X(1.045)(4.3899767)

X =

X = $15,82,260.54

Maximum Pretax lease Payment =

Maximum Pretax lease Payment = $21,09,680.72

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