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))

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.

Explanation / Answer

Depreciation tax shield lost=((2.4*10^6)/5)*(1-34%)
=316800
After tax cost of debt=8%*(1-34%)=5.28%
The aftertax residual value of the asset is an opportunity cost to the leasing decision, occurring at the end of the project life . The NAL of the asset is zero
NAL=0=24000000-X*(1+5.28%)*PVIFA(5.28%,5)-316800*PVIFA(5.28%,5)-(900000/1.0528^5)
PVIFA(5.28%,5)=4.3
2400000=1.0528*4.3X-(316800*4.3)-695846
X=984768.41

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