Today is January 1, 2014. You have just picked up the paper and see an opportuni

Question

Today is January 1, 2014. You have just picked up the paper and see an opportunity to purchase a building for $ 20,000,000 and lease it back to the current tenant.

     So, you decide to call the current tenant, and have learned that the tenant would like to “lease” the building back for ten years, with an option to buy the building back at “fair value” at that point in time. Prior knowledge tells you that similar buildings have an economic life of thirty years. Further, the current tenant would like to report the lease as an operating lease, and would like to make annual lease payments, with the first payment being due on December 31, 2014. Given their current state, the current tenant of the building has an incremental cost of borrowing of 12%.  

     If you purchase the building, you will be entitled to depreciate it. For sake of simplicity, assume that for tax purposes the building is depreciated using the straight

line method over a 32-year period with a salvage value of zero.

     The current tenant has agreed to pay all maintenance, property taxes, and any other costs of ownership.   

     You believe that a building of the type being discussed will appreciate at a rate of

2% per year. If you sell the building at any point in time, you will pay “capital gains” income tax at a rate of 20% of the difference between the selling price and your remaining “cost basis” (i.e. the un-depreciated portion of the initial cost). All other income and benefits is taxed at a rate of 40%.

   Given the information above, please complete the following:

A. (5)     Assuming that you purchase the building with cash, construct a lease that

            generates a pre-tax internal rate of return of 10% per year, satisfies the objectives

            of the client, and has the minimum annual lease payment.

B. (2)    Given the lease that you’ve constructed in Part A, determine the after-tax

            cash flows for each year.   What is the internal rate of return for the after-tax

            cash flows?  

C. (3)     Given your answer to Part B, by how much does your after-tax “Internal Rate

            of Return” increase if you borrow 80% (i.e. $ 16,000,000) of the cost of the

            building, with a ten-year, 8% loan with equal annual payments due on

            December 31 of each year?  

Explanation / Answer

A.

let the lease payment is $X, then

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