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 $3.4 million in annual pretax cost savings. The system costs $9.3 million and will be depreciated straight-line to zero over five years. Wildcat's tax rate is 25 percent, and the firm can borrow at 7 percent. Lambert Leasing Company is willing to lease the equipment to Wildcat. 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 $1,000,000 at the end of the lease. What is the maximum lease payment acceptable to Wildcat? (Do not round intermediate calculations and enter yuor answer in dollars, not millions, rounded to 2 decimal places, e.g., 1,234,567.89.)

Answer 1

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 = ($9,300,000 / 5)(.25)

Depreciation tax shield lost = $465,000

The after tax cost of debt is:

After tax debt cost = .07(1 − .25)

After tax debt cost = .0525, or 5.25%

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 = $9,300,000 − X(1.0525)(PVIFA5.25%,5) − $465,000(PVIFA5.25%,5) - $1,000,000 * (PVIF 5.25%,5)

0 = $9,300,000 - (X * 4.525455) - $465,000 * 4.299719 - $1,000,000 * 0.774265

X = ($9,300,000 - 1,999,370 - 774264.7) / 4.525455

X = 1,442,145.87