Topic: It is important to consider the time value of money along with financial
ID: 2616768 • Letter: T
Question
Topic:
It is important to consider the time value of money along with financial risk when making financial decisions. Determine the best course of action for your company using the information below:
Assume the stock market returns 11.3% per year on average.
Your company has $100,000 to spend for the down payment on the purchase of a new office.
A new office will cost $500,000
To rent a new office it will cost your company $3,500 per month and you will need to sign a 3 year lease.
Find any other information that is necessary to perform the calculation such as the current market rate for a commercial loan.
What should you do: buy an office or lease? Choose the best answer and justify your answer by calculating the time value of money. What other factors should you use besides the time value of money? Why?
Explanation / Answer
We have to arrive at a loan rate for the commercial loan. Let us assume that such a loan will cost 6% per annum
Cost of new office = 500,000
Down payment = 100,000
Loan amount = 400,000
number of months = 36
Interest rate per month = 0.06/12
Monthly Interest payment = PMT(rate,nper,pv) in excel = PMT(0.06/12,36,400000) = 12,168.77
Total loan payment = 12,168.77*36 = 438,075.72
Net cost of purchase = 438,075.75 +100,000 (down payment) = 538,075.75
Net rent over a three year period = 3500*36 = 126,000
Another important factor to consider here is what is the return that you expect from the office and for how long. Since we assume a business to be "going concern", we assume it will have perpetual life.
Considering its perpetual life and assuming it has return of 11.3% which is much higher than assumed loan rate, I would suggest to go for a purchase rather than a rent although rent seems to be good on the short run.
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