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 $2.3 million in annual pretax cost savings. The system costs $9.1 million and will be depreciated straight-line to zero over its five-year life, after which it will be worthless. Wildcat's tax rate is 34 percent, and the firm can borrow at 7 percent. Lambert Leasing Company has offered to lease the drilling equipment to Wildcat for payments of $1,990,000 per year. Lambert's policy is to require its lessees to make payments at the start of the year. What is the NAL for Wildcat? (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) NAL $ What is the maximum lease payment that would be acceptable to Wildcat? (Enter your answer in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) Lease payment $

Explanation / Answer

a. Computation of NAL for Wildcat:
NAL = Investment - after tax lease payments - PV of after tax lease payments - PV of Depreciation tax shield
Here, Investment = $9,100,000
after tax lease payments = $1,990,000 * (1-tax rate i.e., 34%) = 1,313,400
PV of after tax lease payments = PVIFA at cost of debt and 5 years
= 1,313,400* (PVIFA 7%*(1-34%), 5)
=1,313,400* (PVIFA 4.62%, 4)
= 1,313,400* (3.5775) = 4,698,688.5
PV of Depreciation tax shield = [($9,100,000/ 5years)*0.34]* (PVIFA 4.62%, 5)
= 618,800 * (4.3753) = 2,707,435.64
NAL = Investment - after tax lease payments - PV of after tax lease payments - PV of Depreciation tax shield

Therefore, NAL = $9,100,000 - 1,313,400 - 4,698,688.5- 2,707,435.64 = 380,475.86

b. To find the maximum Lease payment, we need to find where the NAL is equal to zero,

and solve for the payment.
Let X be the maximum payment

NAL = 0 = $9,100,000 – X(1.0462)(PVIFA4.62%,5) – 618,800 (PVIFA4.62%,5)
0 = $9,100,000 – X(1.0462)4.3753 – 2,707,435.64
4.577X = 6,392,564.36
X = $1,396,671.26
Therefore, Pretax lease payment = $1,396,671.26 /(1 – .34)= $2,116,168.58

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