The Wildcat Oil Company is trying to decide whether to lease or buy a new comput

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 $2.4 million in annual pretax cost savings. The system costs $9.1 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 8 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

Explanation / Answer

Annual Depreciation = (Cost-salvage Value)/useful life

Annual Depreciation = (9100000-0)/5

Annual Depreciation = 1820000

Annual Depreciation Tax shield = Annual Depreciation*Tax rate

Annual Depreciation Tax shield = 1820000*34%

Annual Depreciation Tax shield = 618,800

PV of Cost of Buying = System Cost - Annual Depreciation Tax shield *(1-(1+r)^-n)/r - Aftertax Residual Value*(1-r)^-n

PV of Cost of Buying = 9100000- 618800*(1-(1+8%)^-5)/8% - 900000*(1-34%) *(1-8%)^-5

PV of Cost of Buying = $ 5,728,056.82

Annual lease Payment = (PV of Cost of Buying /(1-(1+r)^-n)/r)/(1-tax rate)

Annual lease Payment = (5728056.82/((1-(1+8%)^-5)/8%))/(1-34%)

Annual lease Payment = $ 2,173,680

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