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 $3.2 million in annual pretax cost savings. The system costs $8.2 million and will be depreciated straight-line to zero over five years. Wildcat’s tax rate is 22 percent and the firm can borrow at 7 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 $740,000 at the end of the lease.

What is the maximum lease payment acceptable to Wildcat? (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to 2 decimal places, e.g., 1,234,567.89.)

Answer 1

Solution:

Depreciation tax shield lost = ($8,200,000/5)(.22) = $360,800
Aftertax lease payment = $740,000 * (1 - 0.22) = 577,200
Aftertax debt cost = .07 (1 - 0.22) = 5.46%
8,200,000 - 577,200 - 577,200 (P/A , 5.46%, 4) - 360,800 (P/A, 5.46%,5) = 4,055,349.44

NAL = 8,200,000 - X (1.0546) (P/A , 5.46%, 5) - 360,800 (P/A, 5.46%,5)
0 = 8,200,000 - X* 1.0546 * 4.2750 - 360,800 * 4.2750
0 = 8,200,000 - 4.508412 X - 1,542,420
6657580 / 4.508412 = X
X = 1,476,700.79
Maximum pretax lease payment = 1,476,700.79 / (1-0.22) = 1,893,206.14