Top-Quality Stores, Inc., owns a nationwide chain of supermarkets. The company i
ID: 2370035 • Letter: T
Question
Top-Quality Stores, Inc., owns a nationwide chain of supermarkets. The company is going to open another store soon, and a suitable building site has been located in an attractive and rapidly growing area. In discussing how the company can acquire the desired building and other facilities needed to open the new store, Sam Watkins, the company's vice president in charge of sales, stated, "I know most of our competitors are starting to lease facilities rather than buy, but I just can't see the economics of it. Our development people tell me that we can buy the building site, put a building on it, and get all the store fixtures we need for just $849,000. They also say that property taxes, insurance, and repairs would run $19,900 a year. When you figure that we plan to keep a site for 18 years, that's a total cost of $931,800. But then when you realize that the property will be worth at least a half million in 18 years, that's a net cost to us of only $431,800. What would it cost to lease the property?"
"I understand that Beneficial Insurance Company is willing to purchase the building site, construct a building and install fixtures to our specifications, and then lease the facility to us for 18 years at an annual lease payment of $130,000," replied Lisa Coleman, the company's executive vice president.
"That's just my point," said Sam. "At $130,000 a year, it would cost us a cool $2,340,000 over the 18 years. That's three times what it would cost to buy, and what would we have left at the end? Nothing! The building would belong to the insurance company!"
"You're overlooking a few things," replied Lisa. "For one thing, the treasurer's office says that we could only afford to put $352,000 down if we buy the property, and then we would have to pay the other $497,000 off over 4 years at $175,000 a year. So there would be some interest involved on the purchase side that you haven't figured in."
"But that little bit of interest is nothing compared to over 2 million bucks for leasing," said Sam. "Also, if we lease I understand we would have to put up an $7,100 security deposit that we wouldn't get back until the end. And besides that, we would still have to pay all the yearly repairs and maintenance costs just like we owned the property. No wonder those insurance companies are so rich if they can swing deals like this."
"Well, I'll admit that I don't have all the figures sorted out yet," replied Lisa. "But I do have the operating cost breakdown for the building, which includes $8,300 annually for property taxes, $7,900 for insurance, and $3,700 for repairs and maintenance. If we lease, Beneficial will handle its own insurance costs and of course the owner will have to pay the property taxes. I'll put all this together and see if leasing makes any sense with our required rate of return of 18%. The president wants a presentation and recommendation in the executive committee meeting tomorrow. Let's see, development said the first lease payment would be due now and the remaining ones due in years 1
Top-Quality Stores, Inc., owns a nationwide chain of supermarkets. The company is going to open another store soon, and a suitable building site has been located in an attractive and rapidly growing area. In discussing how the company can acquire the desired building and other facilities needed to open the new store, Sam Watkins, the company's vice president in charge of sales, stated, "I know most of our competitors are starting to lease facilities rather than buy, but I just can't see the economics of it. Our development people tell me that we can buy the building site, put a building on it, and get all the store fixtures we need for just $849,000. They also say that property taxes, insurance, and repairs would run $19,900 a year. When you figure that we plan to keep a site for 18 years, that's a total cost of $931,800. But then when you realize that the property will be worth at least a half million in 18 years, that's a net cost to us of only $431,800. What would it cost to lease the property?"
"I understand that Beneficial Insurance Company is willing to purchase the building site, construct a building and install fixtures to our specifications, and then lease the facility to us for 18 years at an annual lease payment of $130,000," replied Lisa Coleman, the company's executive vice president.
"That's just my point," said Sam. "At $130,000 a year, it would cost us a cool $2,340,000 over the 18 years. That's three times what it would cost to buy, and what would we have left at the end? Nothing! The building would belong to the insurance company!"
"You're overlooking a few things," replied Lisa. "For one thing, the treasurer's office says that we could only afford to put $352,000 down if we buy the property, and then we would have to pay the other $497,000 off over 4 years at $175,000 a year. So there would be some interest involved on the purchase side that you haven't figured in."
"But that little bit of interest is nothing compared to over 2 million bucks for leasing," said Sam. "Also, if we lease I understand we would have to put up an $7,100 security deposit that we wouldn't get back until the end. And besides that, we would still have to pay all the yearly repairs and maintenance costs just like we owned the property. No wonder those insurance companies are so rich if they can swing deals like this."
"Well, I'll admit that I don't have all the figures sorted out yet," replied Lisa. "But I do have the operating cost breakdown for the building, which includes $8,300 annually for property taxes, $7,900 for insurance, and $3,700 for repairs and maintenance. If we lease, Beneficial will handle its own insurance costs and of course the owner will have to pay the property taxes. I'll put all this together and see if leasing makes any sense with our required rate of return of 18%. The president wants a presentation and recommendation in the executive committee meeting tomorrow. Let's see, development said the first lease payment would be due now and the remaining ones due in years 1
Explanation / Answer
A. Net Present value of Lease is: -843,472 computed as follows:
Year Cash Flow Present value factor at 16% Net Present Value
year 0 -128000 1 -128000 ( -120,000 + -8000 security deposit = -128000)
year 1 -124500 0.862068966 -107328 ( - 120,000 + -4500 repair = -124,500)
year 2 -124500 0.743162901 -92524
year 3 -124500 0.640657674 -79762
year 4 -124500 0.552291098 -68760
year 5 -124500 0.476113015 -59276
year 6 -124500 0.410442255 -51100
year 7 -124500 0.35382953 -44052
year 8 -124500 0.305025457 -37976
year 9 -124500 0.26295298 -32738
year 10 -124500 0.226683603 -28222
year 11 -124500 0.1954169 -24329
year 12 -124500 0.168462844 -20974
year 13 -124500 0.14522659 -18081
year 14 -124500 0.125195336 -15587
year 15 -124500 0.107927014 -13437
year 16 -124500 0.093040529 -11584
year 17 -124500 0.080207353 -9986
year 18 3500 0.06914427 242 ( +8000 - 4,500=3500) refund security deposit - repairs
total net present value - lease -843472
B. Net Present value of Buy New Facility is:
Year Cash Flow Present value factor at 16% discounted Net Present Value
year 0 -350000 1 -350000 ( - 350,000 down payment)
year 1 -195000 0.862068966 -168103 ( -175,000, -20,000 repair)
year 2 -195000 0.743162901 -144917
year 3 -195000 0.640657674 -124928
year 4 -195000 0.552291098 -107697
year 5 -20000 0.476113015 -9522 ( -20,000 repair)
year 6 -20000 0.410442255 -8209
year 7 -20000 0.35382953 -7077
year 8 -20000 0.305025457 -6101
year 9 -20000 0.26295298 -5259
year 10 -20000 0.226683603 -4534
year 11 -20000 0.1954169 -3908
year 12 -20000 0.168462844 -3369
year 13 -20000 0.14522659 -2905
year 14 -20000 0.125195336 -2504
year 15 -20000 0.107927014 -2159
year 16 -20000 0.093040529 -1861
year 17 -20000 0.080207353 -1604
year 18 480000 0.06914427 33189 ( -20000 repair, + 500,000 value of building)
total net present value - own -921466
difference between lease and own in favor of lease -77995
2. Assuming the future sale value of considered as part of cost to lease because the company foregoes ownership of the facility , $500,000 discounted at 16% for 18 years is -$34572 in term of present value . computed as follows: ( $ 500,000 x .06914427)
.
It is still better to lease than to own, even after considering the company lose opportunity to own the building.
3. Tax shield on depreciation if the company owns the building is NOT considered.
Tax shield on lease is not considered also.
In this case, the option to buy cash flow includes interest charges, while the lease has hidden interest charge.
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