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 $3.9 million in annual pretax cost savings. The system costs $8.9 million and will be depreciated straight-line to zero over five years. Wildcat’s tax rate is 24 percent and the firm can borrow at 6 percent. Lambert’s policy is to require its lessees to make payments at the start of the year.

  

Suppose it is estimated that the equipment will have an aftertax residual value of $880,000 at the end of the lease. What is the maximum lease payment acceptable to Wildcat?

Answer 1

	Answer
a	Purchase asset
	System Cost	$        8,900,000.00
	Pre tax cost savings	$        3,900,000.00
	Life of system	5 years
	Depreciation	Cost /Life
		$        1,780,000.00
	Pre tax cost savings	$        3,900,000.00
	Less : Depreciation	$        1,780,000.00
	Pre tax cost savings	$        2,120,000.00
	tax @ 24%	$           508,800.00
	Post tax savings	$        1,611,200.00
	Add : Depreciation	$        1,780,000.00
	Net cash flows	$       3,391,200.00
	Discount rate	6%
	Presnet value of cash flows	PVAF(6%,5years)*1611200
	PVAF(6%,5years)	1-(1+r)^-n/r
		(1-(1.06)^-5)/0.06
		4.2124
	Presnet value of cash flows	$     14,284,968.07
	NPV	Present Value of cash inflows - Present value of cash outflows
		14284968.07-8900000
		$       5,384,968.07
b	Asset on Lease
	Pre tax cost savings	$        3,900,000.00
	Lease Payment	X
		3900000-X
	Tax @ 24%	(3900000-X)*24%
	Net cash flows	(3900000-X)*76%
	After tax residual Value	$           880,000.00
	Present value	880000/(1.06)^5
		$           657,587.19
	Discount rate	6%
	To be indifference between purchase and lease the NPVs under two options should be equal
	Presnet value of cash flows	((3900000-X)*76%*4.2124)+657587.19
	NPV	((3900000-X)*76%*4.2124)+657587.19
	$                   5,384,968.07	((3900000-X)*76%*4.2124)+657587.19
	5384968.07-657587.19	((3900000-X)*76%*4.2124)
	$                   4,727,380.88	((3900000-X)*76%*4.2124)
	4727380.88/4.2124	(3900000-X)*76%
	$                   1,122,253.56	(3900000-X)*76%
	1122253.56/0.76	(3900000-X)
	1476649.421	(3900000-X)
	X	3900000-1476649.421
	X	$        2,423,350.58
	Maximum Lease payment Acceptable	$       2,423,350.58