The Nebraska Institute of Science (NIS) pools all of its endowment funds so that

Question

The Nebraska Institute of Science (NIS) pools all of its endowment funds so that it can obtain the benefits of a large and diverse investment portfolio. The institute recently acquired a commercial office building as an investment property. The cost was $12 million and its economic life was expected to be 15 years. Upon acquiring the building, NIS signed a 15-year lease with a tenant. The annual rent was $1.3 million, with the tenant responsible for all maintenance and other operating costs.

Instructions:

1. Suppose that the NIS did not charge depreciation and distributed to expendable funds the entire ‘‘income’’ earned on the office building.

a. What would be the total amount distributed over the 15-year life of the building?

b. Assuming that NIS’s estimate of economic life was correct, what would likely be the market value of the building when the lease expired? Would NIS have had available any cash for the acquisition of other assets that would compensate for the decline in value of the building?

2. Suppose NIS charged depreciation and distributed to expendable funds the entire ‘‘income’’ earned on the office building.

a. What would be the total amount distributed over the 15-year life of the building?

b. Assuming that NIS’s estimate of economic life was correct, what would likely be the market value of the building when the lease expired?

c. Would NIS have had available any cash for the acquisition of other assets that would compensate for the decline in value of the building?

3. Suppose NIS charged depreciation and distributed to expendable funds the entire ‘‘income’’ earned on the office building.

a. What would be the total amount distributed over the 15-year life of the building?

b. Assuming that NIS’s estimate of economic life was correct, what would likely be the market value of the building when the lease expired? Would NIS have had available any cash for the acquisition of other assets to compensate for the decline in value of the building?

Explanation / Answer

Answer:

1)

a) Incase of no depreciation, the whole amount of $1.3 million would be distributed during the 15 year of the lease.

The total amount will be: 15*$1.3 million = $19.5million.

b) At the time of lease expiration, building’s market value will be zero. Assuming that NIS’s estimation was appropriate that was the economic life of the asset is 15 years. Thus, it is clear that NIS will have no cash on hand to purchase any other asset.

2)

a) In this case the amount of annual depreciation is as follows:$12million/15years = $0.8million

.Annual income = $1.3million - $0.8million= $0.50million.

Thus, the amount of income over the entire lease period is:

Entire lease period = Annual income * Number of years

  = $0.5*15= $7.5million

b) In this case, again the market value of the building will be zero at the end of lease.NIS will have $12million on hand. Amount on hand = Amount collected as rent – Amount from entire lease period= $19.5 million – $7.5million= $12 million. In this case, this amount along with the accumulated earnings will enable NIS to acquire other assets.

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