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 $3.4 million in annual pretax cost savings. The system costs $7.5 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 8 percent. Lambert Leasing Company has offered to lease the drilling equipment to Wildcat for payments of $1.71 million 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 $375,000 security deposit at the inception of the lease. Calculate the NAL with the security deposit. (A negative answer should be indicated by a minus sign. Do not round intermediate calculations and enter your answer in dollars, not millions, rounded to 2 decimal places, e.g., 1,234,567.89.)

Answer 1

1)	Discount rate = 8%*(1-24%) =	6.08%
2)	Loan installments = 7500000*0.08*1.08^5/(1.08^5-1) =	$ 18,78,423
3)	The after tax cash flows for leasing and buying are worked out below:
		0	1	2	3	4	5
	LEASING:
	After tax lease rent [1710000*(1-24%)]	$-12,99,600	$ -12,99,600	$     -12,99,600	$-12,99,600	$-12,99,600
	Security deposit	$   -3,75,000					$      3,75,000
	After tax cash outflows	$-16,74,600	$ -12,99,600	$     -12,99,600	$-12,99,600	$-12,99,600	$      3,75,000
	BUYING:
	Loan amortization:
	Beginning balance of loan		$ 75,00,000	$      62,21,577	$ 48,40,880	$ 33,49,728	$    17,39,283
	Interest at 8%		$     6,00,000	$         4,97,726	$    3,87,270	$    2,67,978	$      1,39,143
	Total		$ 81,00,000	$      67,19,303	$ 52,28,151	$ 36,17,706	$    18,78,425
	Installment		$ 18,78,423	$      18,78,423	$ 18,78,423	$ 18,78,423	$    18,78,425
	Ending balance of loan		$ 62,21,577	$      48,40,880	$ 33,49,728	$ 17,39,283	$                     0
	Depreciation [7500000/5]		$ 15,00,000	$      15,00,000	$ 15,00,000	$ 15,00,000	$    15,00,000
	After cash flows of buying:
	Principal repayment		$ -12,78,423	$     -13,80,697	$-14,91,153	$-16,10,445	$ -17,39,282
	After tax interest		$   -4,56,000	$       -3,78,272	$   -2,94,326	$   -2,03,663	$     -1,05,748
	Tax shield on depreciation at 24%		$     3,45,000	$         3,45,000	$    3,45,000	$    3,45,000	$      3,45,000
	After tax cash outflows		$ -13,89,423	$     -14,13,969	$-14,40,478	$-14,69,108	$ -15,00,031
4)	The PV of leasing and buying are worked out below using a discount rate of 6.08%:
	PVIF at 6.08% {PVIF = 1/1.1^n]	1	0.94268	0.88865	0.83772	0.78971	0.74444
	PV of leasing	$-16,74,600	$ -12,25,113	$     -11,54,895	$-10,88,702	$-10,26,303	$      2,79,167
	Total PV of leasing	$-58,90,447
	PV of buying		$ -13,09,788	$     -12,56,530	$-12,06,719	$-11,60,165	$ -11,16,690
	Total PV of buying	$-60,49,892
5)	NAL = -5890447-(-6049892) =	$    1,59,444
6)	As the NAL of leasing is positive, leasing should be preferred.

7) As the pre-tax cost savings are the same for both the alternatives, they are not included in the cash flows.