chap 21 hww instructions I help E) Save & Exit I submit ! Question 2 (of 6) 10.0

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chap 21 hww instructions I help E) Save & Exit I submit ! Question 2 (of 6) 10.00 points 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 t must use the system to stay competitive, it will provide S2.2 million in annual pretax cost savings. The system costs $8.9 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 9 percent. Lambert Leasing Company has offered to lease the drilling equipment to Wildcat for payments of $2,060,000 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 References eBook & Resources Worksheet Section: 21.07 Debt Displacement and Lease Valuation Difticulty: 2 Intermediate Section: 21.08 Does Leasing Ever Pay? The Base Case

Explanation / Answer

Solution:

a. The pretax cost savings are not relevant to the lease versus buy decision, since the firm will definitely use the equipment and realize the savings regardless of the financing choice made. The depreciation tax shield is:

Depreciation tax shield lost = ($8,900,000/5) (.34) = $605,200

And the after tax lease payment is:

After tax lease payment = $2,060,000(1 – .34) = $1,359,600

The after tax cost of debt is:

After tax debt cost = .09(1 – .34) = .0594 or 5.94%

With these cash flows, the NAL is:

NAL = $8,900,000 – 1,359,600 – $1,359,600(PVIFA5.94%, 4) – $605,200(PVIFA5.94%,5)

NAL = $269,273.42

The equipment should be leased.

b. To find the maximum payment, we find where the NAL is equal to zero, and solve for the payment. Using X to represent the maximum payment:

NAL = 0 = $8,900,000 – X (1.0594) (PVIFA5.94%,5) – $605,200(PVIFA5.94%,5)

X = $1,419,841.87

So the maximum pretax lease payment is:

Pretax lease payment = $1,419,841.87/ (1 – .34) = $2,151,275.56

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