Your firm owns a lot in center city Philadelphia. The purchase price of the lot
ID: 2641901 • Letter: Y
Question
Your firm owns a lot in center city Philadelphia. The purchase price of the lot in 2002 was $350,000 and today its market value is 1.2 million
Your job is to determine which of the following two options would add the most value to the firm.
OPTION 1:
Build an office high rise with 450,000 square feet of office space. The street level will be dedicated to retail.
Expected revenues per square foot of office space is $22
Retail space is expected to rent for $180,000 a year.
The cost of the building is $85 million and will be financed by borrowing $40,000,000 and paying the balance with cash. The cost of debt is 6% and the cost of cash 8%. (The cost of cash is the forgone return from investment). The firm
Explanation / Answer
1. Initial Cost outlay for option 1
Initial cost outlay = $ 85,000,000 which is the cost of the building required
2. Annual Revenue expected for Option 1
Particulars
Amount
Rent from retail space (A)
$ 180,000
Revenue from Office Space ($ 22 * 450,000 square feet (B)
$ 9,900,000
Total Revenue (A+B)
$ 10,080,000
3. Annual Depreciation expense
Particulars
Amount
Land Cost
$ 350,000
Building Cost
$ 85,000,000
Total Assets with life 10 years
$ 85,350,000
Depreciation
$ 8,535,000
4. Salvage value to be taken into consideration in year 10
Salvage Value = Total Cost - Total Depreciation till year 9
Salvage Value = 85,350,000 - 76,815,000
= $ 8,535,000
5. Operating Cash Flows for Option 1
Particulars
Amount
Rent from retail space (A)
$180,000
Revenue from Office Space ($ 22 * 450,000 square feet (B)
$9,900,000
Total Revenue (A+B)
$10,080,000
Less:
Depreciation
$8,535,000
Interest expense on debt ($ 40 million at 6%)
$2,400,000
Interest expense on cash ($ 45 million at 8%)
$3,600,000
Total Income / (Loss) (A)
($4,455,000)
Tax at 30%
$0
Add: Depreciation in Total Loss to get operating cash flows (B)
$8,535,000
Operating Cash Flows (A+B)
$4,080,000
6. Operating Cash Flow in year 10
It will be same as above in point 5 sincec no data about salvage value is provided.
7. NPV for Option 1
Taking cost of cash as the market rate and hence the discount rate = 8%
Particulars
Amount
Operating Cash Flows (A)
$4,080,000
Add: Saving due to non payment of Income Tax (30% of $ 4,455,000) (B)
$1,336,500
Total cash flows of the option 1 (A+B) ( C )
$5,416,500
Annuity Value for $ 1 at 8% for 10 years (Sum of Present Value of $ 1 for 10 years) (D)
$6.71
Total Present Value of Inflow of cash (C * D)
$36,344,715
Total Cash outflow initially
$85,000,000
NPV
($48,655,285)
Particulars
Amount
Rent from retail space (A)
$ 180,000
Revenue from Office Space ($ 22 * 450,000 square feet (B)
$ 9,900,000
Total Revenue (A+B)
$ 10,080,000
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