The Wildcat Oil Company is trying to decide whether to lease or buy a new comput
ID: 2655113 • 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 Leasing Company has offered to lease the drilling equipment to Wildcat for payments of $2.15 million 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? What is the maximum lease payment?
Please state what is the NAL and maximum lease payment amount? Also provide calculations, Thank You!!
Explanation / Answer
a)
Buying
Initial Investment = -9,400,000
Annual Depreciation = 9400000/5 = $ 1,880,000
Annual Cash Flow = annual pretax cost savings*(1-tax rate) + Depreciation*tax rate
Annual Cash Flow = 2700000*(1-34%) + 1880000*34%
Annual Cash Flow = 2,421,200
NPV = - Initial Investment + Annual Cash Flow *PVA(9%,5)
NPV = - 9400000 + 2421200*3.889651
NPV = $ 17623
Leasing
NPV = Annual Pretax cost savings*(1-tax Rate)*PVA(9%,5) - Annual Lease Payment*(1-tax rate)*(1 + PVA(9%,4)
NPV = 2700000*(1-34%)*3.889651 - 2150000*(1-34%)*(1+3.239720)
NPV = $ 915,195.40
NAL for Wildcat = NPV in Leasing - NPV in buying
NAL for Wildcat = 915195.40 - 17623
NAL for Wildcat = $ 897,572.40
b)
Maximum Lease Payment is the Lease Payment where NPV at Buying and Leasing are same
NPV = Annual Pretax cost savings*(1-tax Rate)*PVA(9%,5) - Annual Lease Payment*(1-tax rate)*(1 + PVA(9%,4)
17623 = 2700000*(1-34%)*3.889651 - Annual Lease Payment*(1-34%)*(1+3.239720)
Annual Lease Payment= (6931358.08 - 17623 )/ ((1-34%)*(1+3.239720))
Annual Lease Payment= $ 2,470,766.04
Answer
Maximum Annual Lease Payment= $ 2,470,766.04
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