Question

ABC 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. This system will provide $3 million in annual pre-tax cost savings. The system costs $10 million and will be depreciated straight-line to zero over five years. The company tax rate is 30%. The company can borrow at 10%. LLC Company has offered to lease the computer-assisted drilling system to ABC for payments of $2.1 million per year. LLC policy is to require its lessees to make payments at the beginning of the year.

(a) Calculate the NAL for ABC

(b)Calculate the maximum lease payment that would be acceptable to ABC.

(c) Calculate the maximum lease payment that would be acceptable to the company if the drilling system will have an after-tax residual value of $500,000 at the end of the lease period

(d)If LLC requires ABC to pay a $500,000 as a security deposit and the least payment is still $2.1 M, is it advantageous for ABC to lease the drilling system?

Answer 1

a)

ABC Company - Calculation of Net Advantage to Leasing
Year	Cost of asset	Lease Payments	After Tax Lease payments	Loss Dep. Tax Shield	Total Cash Flow	Present Value	Discount Factor@10%
0	10,000,000	0	0	0	10,000,000	10,000,000	1
1	0	-2,100,000	-1470000	-600000	-2070000	-2070000	1
2	0	-2,100,000	-1470000	-600000	-2070000	-1881818	0.90909
3	0	-2,100,000	-1470000	-600000	-2070000	-1710744	0.82645
4	0	-2,100,000	-1470000	-600000	-2070000	-1555222	0.75131
5	0	-2,100,000	-1470000	-600000	-2070000	-1413838	0.68301
Total	10,000,000	-10,500,000	-7,350,000	-3,000,000	-350,000	1,368,379

b.

The maximum lease payment that would be acceptable to ABC company is where present values of buying and lease options are equal.

As the present value of buying a drilling machine is known, the equation can be built as below:

10000000 = ((x-0.30x)+600000)*1+((x-0.30x)+600000)*0.90909+((x-0.30x)+600000)*0.82645+((x-0.30x)+600000)*0.75131+((x-0.30x)+600000)*0.68301

Where x = Lease payment which is unknown

x-0.30x is net cash outflow after saving tax on lease payments.

Depreciation tax shield in the form outflow = 3000000/5 = 600000

Lease payments are discounted to present value at a borrowed rate of 10% and then summed up.

10000000 = 0.7x+600000+0.636364x+545454+0.578512x+495870+0.52592x+450786+0.478109x+409806.

-2.91890x = 2501916-10000000

x = 7498084/2.91890

=$2,568,805

C)

Present Value of residual value of Drilling Machine after the end of 5 years = 500,000 * 0.62092

= $310,460

Net Investment if Drilling Machine is bought = 10000000-310460 = $9,689,540

Depreciation per year = 9689540/5 = 1937908

Loss of dep Tax shield = 1937908*30% = 581,372.4

Substituting these values in the above equation in b

9689540 = 0.7x+581372.4+0.636364x+528520+0.578512x+480473+0.52592x+436793+0.478109x+397085

2.91890x = 2424244-9689540

2.91890x =-7265296

x = $2,489,053

d)

Yes.

It losses interest on the deposit for 5 years.

The present value of cumulative interest loss is $189,540 WHICH IS LOWER THAN THE ADDITIONAL COST OF BUYING $1,368,379.

So leasing is advantageous.

Monthly Interest & Present Value

50000	45454.55
50000	41322.31
50000	37565.74
50000	34150.67
50000	31046.07
250000	189539.3

Note: Instalment of the lease payment is paid at the beginning, 0 to 4 years discount factor values @ 10% are used. In calculating tax implications for lease payments and depreciation tax shield also followed the same.