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 $1.2 million in annual pretax cost savings. The system costs $6.7 million and will be depreciated straight-line to zero over 4 years. Wildcat's tax rate is 35 percent, and the firm can borrow at 11 percent. Lambert Leasing Company has offered to lease the drilling equipment to Wildcat for payments of $1,750,000 per year. Lambert's policy is to require its lessees to make payments at the start of the year. Lambert requires Wildcat to pay a $270,000 security deposit at the inception of the lease. What is the NAL of leasing the equipment?

Question

Quizplus · Accepted Answer

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.Depreciation tax shield lost = ($6,700,000/4) (0.35) = $586,250Aftertax lease payment = $1,750,000 (1 - 0.35) = $1,137,500Aftertax debt cost = 0.11 (1 - 0.35) = 0.0715The security deposit is a cash outflow at the beginning of the lease and a cash inflow at the end of the lease when it is returned.NAL = $6,700,000 - $270,000 - $1,137,500 - $1,137,500 (PVIFA_{7.15% ,3}) - $586,250(PVIFA_{7.15%, 4}) + $270,000/1.0715⁴NAL = $541,287

The Wildcat Oil Company Is Trying to Decide Whether to Lease