Delen is considering opening an office in a new market that would allow it to in

Question

Delen is considering opening an office in a new market that would allow it to increase it annual sales by $ 2.5 million. Cost of sales is estimated to be 40% of the sales and corporate overheads would increase by $300000, not including the cost of either acquiring or leasing office space. Th e company will have to invest $ 2.5 million in office furniture, office equipment and other upfront costs associated with opening the new office considering the costs of owning or leasing the office space. A small office building could be purchased at for sole use by the corporation at $3.9 million of which $600000 of the purchase price would represent building value. The cost of the building would be depreciated over 39 years. The corporation is in the 30% tax bracket. An investor is willing to purchase the building and lease it to the corporation at $ 450000 per year for a term of 15 years with the corporation paying all the real estate expenses. Real estate expenses are estimated at 50% of the lease payments. Estimates are that the property value will increase over 15 year lease term to a sale of 4$4.9 million at the end of the years. If the property is purchased, it would be financed with an interest only mortgage of $ 2,730,000 at an interest rate of 10% with balloon payment due after 15 years. Calculate the IRR and advise client whether to lease or own property

Explanation / Answer

Answer IRR of cash outflow under leasing Alternative Year Revenue Lease Payment Real estate Expenses Total Payment Income Tax @ 30% Net Cash in flow PVIFA @ 12%, 15 years Total P V 01- to 15 Years 1200000 450000 225000 675000 525000 157500 367500 6.811 2503043 Invest in office furntiure 2500000 Total NPV 3042.5 IRR of Lease = 12% Year Revenue Depreciation Income Tax @30% Net Cash Inflow PVIFA 23% , 15 Years Total PV 01- to 15 Years 1200000 15385 1184615 355385 844615 4.153 3507688 Add PV of sales value 4900000 PVIF 23% ,15 year 0.448 2195200 Less Interest payments Interest Payments 2554068 tax save 766220 Principal Payment 2730000 Net cash out flow 4517848 PVIF 23% ,15 year 0.448 2023996 Total PV of cash flow 3678892 Less Initial out lay Down payment of building 1170000 Invest in office furntiure 2500000 Total NPV 8892 IRR of purchased = 23% Therefore company should purchased the property Revenue 2500000 Less Cost of goods sold 1000000 Gross margin 1500000 Less Overhead 300000 Net Profit 1200000

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