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 $2.7 million in annual pretax cost savings. The system costs $9.4 million and will be depreciated straight-line to zero over five years. Wildcat's tax rate is 34 percent, and the firm can borrow at 9 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 $900,000 at the end of the lease. What is the maximum lease payment acceptable to Wildcat? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))

  

Lease payment

$

Answer 1

Annual pre-tax savings	2700000
Less: Tax @34%	918000
Annual post tax savings	1782000
Residual value	900000
Less: Tax @34%	306000
Tax adjusted residual value	594000

Year	Annual post tax savings	Residual net	Total benefit	PV factor @9% pa	Present value of total benefit ($)
1	1782000		1782000	0.917431	1634862
2	1782000		1782000	0.84168	1499874
3	1782000		1782000	0.772183	1376031
4	1782000		1782000	0.708425	1262414
5	1782000	594000	2376000	0.649931	1544237
Maximum tax adjusted lease payment present value				3.889651	7317418

Pre-tax lease payment maximum (73174718 x 100/66)	11086997
Annual lease payment (11086997/3.90)	2842820

Hence, the maximum annual lease payment should be $2,842,820 .

Note:

The pre-tax lease payment has been calculated by (73174718 x 1000/66) because the rate of tax is 34% hence, 100-34 = 66.

Annual lease payment has been calculated by dividing the maximum amount of lease payment pre-tax with the present value factor of year 1 to 5 @9% per annum.