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 $850,000 in annual pretax cost savings.The system costs $8 million and will be depreciated straight-line to zero over 5 years.Wildcat's tax rate is 34 percent,and the firm can borrow at 8 percent.Lambert Leasing Company has offered to lease the drilling equipment to Wildcat for payments of $2,040,000 per year.Lambert's policy is to require its lessees to make payments at the start of the year.What is the maximum lease payment that would be acceptable to the company?
A)$1,893,231
B)$1,896,996
C)$1,904,506
D)$1,906,318
E)$1,911,472

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 = ($8,000,000/5) (0.34) = $544,000Aftertax debt cost = 0.08 (1 - 0.34) = 0.0528NAL = 0 = $8,000,000 - X (1.0528) (PVIFA_{5.28%, 5}) - $544,000(PVIFA_{5.28%, 5});X = $1,252,017.09Pretax lease payment = $1,252,017.09/(1 - 0.34) = $1,896,996

The Wildcat Oil Company Is Trying to Decide Whether to Lease