The Wildcat Oil Company is trying to decide whether to lease or buy a new comput
ID: 2532723 • Letter: T
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))
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 $9.4 million and will be depreciated straight-line to zero over five years. Wildcat's tax rate is 34 percent, and the firm can borrow at 9 percent. Lambert's policy is to require its lessees to make payments at the start of the year.
Explanation / Answer
Annual pre-tax savings
2700000
Less: Tax @34%
918000
Annual post tax savings
1782000
Residual value
900000
Less: Tax @34%
306000
Tax adjusted residual value
594000
Year
Annual post tax savings
Residual net
Total benefit
PV factor @9% pa
Present value of total benefit ($)
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.
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
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