Question

New Oil Co. is considering replacement of their highly specialised drilling equipment. The new equipment is computer assisted and therefore provides New Oil with $2.9 million in annual pre-tax savings. New Oil can purchase the equipment at $9.7 million which will be depreciated straight-line to zero over five years. The local bank is prepared to provide New Oil with $2.9 million loan at an interest rate of 9 percent with annual repayments spread over five years. Alternatively, New Oil can lease this equipment from ABC Leasing The lease contract will require an annual payment of $2.15 million per year payable at the beginning of each year for five years Required: a) Assuming a tax rate of 34% for New Oil, calculate the NAL of leasing rather than buying this equipment Should New Oil lease or buy this equipment? (10 marks) b) What is the maximum lease payment that would be acceptable to New Oil? (3 marks)

Answer 1

	CASH FLOW FOR BORROW AND BUY OPTION
	Equipment Cost	$9,700,000
	Borrowed amount	$2,900,000
	Initial Cash Flow (Year 0)	($6,800,000)	(9700000-2900000)
	Annual Depreciation =9700000/5=	$1,940,000
	INTEREST AND PRINCIPAL REPAYMENT ON AMOUNT BORROWED
Pv	Amount Borrowed	$2,900,000
Nper	Number of years of repayment	5
Rate	Interest Rate	9%
PMT	Annual repayment in five equal instalments	$745,568	(Using PMT function of excelwith Rate=9%,Nper=5, Pv=-2900000
	REPAYMENT SCHEDULE
	Year		1	2	3	4	5
A	Beginning Balance		$2,900,000	$2,415,432	$1,887,253	$1,311,537	$684,007
B	Amount of annual payment		$745,568	$745,568	$745,568	$745,568	$745,568
C=A*9%	Interest		$261,000	$217,389	$169,853	$118,038	$61,561
D=B-C	Principal		$484,568	$528,179	$575,715	$627,530	$684,007
E=A-D	Ending Balance		$2,415,432	$1,887,253	$1,311,537	$684,007	$0
	Annual Savings	$2,900,000
N	Year	0	1	2	3	4	5
a	Initial Cash Flow	($6,800,000)
	Annual Cash Inflows:
.(1)	Annual Savings		$2,900,000	$2,900,000	$2,900,000	$2,900,000	$2,900,000
,(2)	Interest Cost for amount borrowed		-$261,000	-$217,389	-$169,853	-$118,038	-$61,561
.(3)	Depreciation expense		-$1,940,000	-$1,940,000	-$1,940,000	-$1,940,000	-$1,940,000
.(5)=(1)+(2)+(3)	Earning Before Interest and Taxes(EBIT)		$699,000	$742,611	$790,147	$841,962	$898,439
	Taxes(34%)		-$237,660	-$252,488	-$268,650	-$286,267	-$305,469
	Net Income/(Loss)		$461,340	$490,123	$521,497	$555,695	$592,970
	Add back depreciation		$1,940,000	$1,940,000	$1,940,000	$1,940,000	$1,940,000
b	Total Operating Cash Flow		$2,401,340	$2,430,123	$2,461,497	$2,495,695	$2,532,970
c	Cash flow for repayment of principal		-$484,568	-$528,179	-$575,715	-$627,530	-$684,007
CF=a+b+c	PROJECT NET CASH FLOW	-$6,800,000	$1,916,772	$1,901,944	$1,885,782	$1,868,165	$1,848,963
	After tax interest =9*(1-0.34)=	5.9%						SUM
PV=CF/(1.059^N)	Present Value of Cash Flow	-$6,800,000	$1,809,983	$1,695,922	$1,587,828	$1,485,359	$1,388,188	$1,167,280
	Net Present Value	$1,167,280
	CASH FLOW FOR LEASE OPTION
N	Year	0	1	2	3	4	5
.(1)	Annual Lease Payment	($2,150,000)	($2,150,000)	($2,150,000)	($2,150,000)	($2,150,000)
.(2)	Annual Savings		$2,900,000	$2,900,000	$2,900,000	$2,900,000	$2,900,000
.(3)=.(1)+.(2)	Earning Before Interest and Taxes(EBIT)	($2,150,000)	$750,000	$750,000	$750,000	$750,000	$2,900,000
a=.(3)*34%	Taxes(34%)	$731,000	($255,000)	($255,000)	($255,000)	($255,000)	($986,000)
b=.(3)+a	Net Income/(Loss)	($1,419,000)	$495,000	$495,000	$495,000	$495,000	$1,914,000
CF=b	PROJECT NET CASH FLOW	-$1,419,000	$495,000	$495,000	$495,000	$495,000	$1,914,000	SUM
PV=CF/(1.059^N)	Present Value of Cash Flow	-$1,419,000	$467,422	$441,381	$416,790	$393,569	$1,437,018	$1,737,180
	Net Present Value	$1,737,180
	LEASE OPTION has higher NPV
	New Oil should choose LEASE OPTION
b	Maximum Lease payment
N	Year	0	1	2	3	4	5
.(1)	Annual Lease Payment	($2,343,000)	($2,343,000)	($2,343,000)	($2,343,000)	($2,343,000)
.(2)	Annual Savings		$2,900,000	$2,900,000	$2,900,000	$2,900,000	$2,900,000
.(3)=.(1)+.(2)	Earning Before Interest and Taxes(EBIT)	($2,343,000)	$557,000	$557,000	$557,000	$557,000	$2,900,000
a=.(3)*34%	Taxes(34%)	$796,620	($189,380)	($189,380)	($189,380)	($189,380)	($986,000)
b=.(3)+a	Net Income/(Loss)	($1,546,380)	$367,620	$367,620	$367,620	$367,620	$1,914,000
CF=b	PROJECT NET CASH FLOW	-$1,546,380	$367,620	$367,620	$367,620	$367,620	$1,914,000	SUM
PV=CF/(1.059^N)	Present Value of Cash Flow	-$1,546,380	$347,139	$327,799	$309,536	$292,291	$1,437,018	$1,167,402
	Net Present Value	$1,167,402
	MaximumLEASE Payment	$2,343,000
									Cupboardy Foht IN Allahment Number Styles Lens Editihg H11 : x fix =PMT(H10,49,-48) H I J K L 5 Annual Depreciation =9700000/5= $1,940,000 8 Pv 9 Nper 10 Rate 11 PMT INTEREST AND PRINCIPAL REPAYMENT ON AMOUNT BORROWED Amount Borrowed $2,900,000 Number of years of repayment Interest Rate 9% Annual repayment in five equal instalments $745,568 (Using PMT function of excelwith Rate=9%,Nper=5, Pv=-2900000 DAVATOIDU