$40,200 26,740 16,610 $83,550 Problem 6-10 Dunn Inc. owns and operates a number

Question

$40,200 26,740 16,610 $83,550 Problem 6-10 Dunn Inc. owns and operates a number of hardware stores in the New England region. Recently, the company has decided to locate another store in a rapidly growing area of Maryland. The company is trying to decide whether to purchase or lease the building and related facilities.

Purchase: The company can purchase the site, construct the building, and purchase all store fixtures. The cost would be $1,865,700. An immediate down payment of $403,200 is required, and the remaining $1,462,500 would be paid off over 5 years at $367,800 per year (including interest payments made at end of year). The property is expected to have a useful life of 11 years, and then it will be sold for $506,700. As the owner of the property, the company will have the following out-of-pocket expenses each period.

Property taxes (to be paid at the end of each year) $40,200 Insurance (to be paid at the beginning of each year) 26,740 Other (primarily maintenance which occurs at the end of each year) 16,610 $83,550
Lease: First National Bank has agreed to purchase the site, construct the building, and install the appropriate fixtures for Dunn Inc. if Dunn will lease the completed facility for 11 years. The annual costs for the lease would be $271,400. Dunn would have no responsibility related to the facility over the 11 years. The terms of the lease are that Dunn would be required to make 11 annual payments (the first payment to be made at the time the store opens and then each following year). In addition, a deposit of $102,000 is required when the store is opened. This deposit will be returned at the end of the 11th year, assuming no unusual damage to the building structure or fixtures.

Compute the present value of lease vs purchase. (Currently, the cost of funds for Dunn Inc. is 10%.) (Round answers to 0 decimal places, e.g. $458,581.)

Lease Purchase Present value   $ $
Which of the two approaches should Dunn Inc. follow?

Dunn Inc. should Purchase Lease the facilities

Explanation / Answer

Answer:  FV of purchase option = 1865700 - 506700 + 83,550 = 1442550

PV of purchase option = FV x Factor (n = 11, i = 10%) (Present value of 1 table)

= 1442550 x 0.3505 =$505613.78

FV of lease option = 12 x 271400 = 3256800

PV of lease option = FV x factor = 3256800x 0.3505 = $1141508.4

So, the purchase option is the least expensive, then Dunn Inc. should follow the purchase option.

Purchase option Lease option Present value $505613.78 $1141508.4

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