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 $600,000 in annual pretax cost savings. The system costs $5.5 million and will be depreciated straight-line to zero over five years. Wildcat’s tax rate is 34 percent, and the firm can borrow at 9 percent. Lambert Leasing Company has offered to lease the drilling equipment to Wildcat for payments of $1,240,000 per year. Lambert’s policy is to require its lessees to make payments at the start of the year.

Return to the case of the diagnostic scanner used in Problems 1 through 6. Suppose the entire $2,000,000 purchase price of the scanner is borrowed. The rate on the loan is 8 percent, and the loan will be repaid in equal installments. Create a lease versus buy analysis that explicitly incorporates the loan payments. Show that the NPV of leasing instead of buying is not changed from what it was in Problem 1. Why is this so?

Data from Problem 1

You work for a nuclear research laboratory that is contemplating leasing a diagnostic scanner (leasing is a very common practice with expensive, high-tech equipment). The scanner costs $2,000,000, and it would be depreciated straight-line to zero over four years. Because of radiation contamination, it will actually be completely valueless in four years. You can lease it for $600,000 per year for four years.

Assume that the tax rate is 35 percent. You can borrow at 8 percent before taxes. Should you lease or buy?