You are seeking office space for your small business, and you are considering tw

Question

You are seeking office space for your small business, and you are considering two different 5 year leases. Lease A is a net lease with steps. The rent will start at $7/sqft and increase by $3/per square foot each year. Lease B is a net lease with 1 free year. The rent will start at $7/sqft and increase by $2/sqft each year, except for year 2, in which you will receive free rent. If you are otherwise indifferent between the two leases and the current market risk free rate is 2.5%, which lease will be more cost-effective over the 5 year term?

The leases will have equal cost over the 5 year period

Lease A

Cannot be determined from information given.

Lease B

The leases will have equal cost over the 5 year period

Lease A

Cannot be determined from information given.

Lease B

Explanation / Answer

Calculating the Present Value of the Lease under 2 different plans;

Plan A (Lease A);

Lease for the First Year = $7/ sqft

Lease for the Second Year = $10/sqft

Lease for the Third Year = $13/sqft

Lease for the Fourth Year = $16/sqft

Lease for the Fifth Year = $19/sqft

Note: since Leases are increasing over $3/sqft per year

Current Market Rate = 2.5%

PV of leases = Lease for the First Year/ (1+ current market rate)^1 + Lease for the second Year/ (1+ current market rate)^2 + Lease for the Third Year/ (1+ current market rate)^3 + Lease for the Fourth Year/ (1+ current market rate)^4 + Lease for the Fifth Year/ (1+ current market rate)^5

Or, PV of leases = 7/ (1.025) + 10/ (1.025) ^2 + 13/ (1.025) ^3 + 16/ (1.025) ^4 + 19/ (1.025) ^5

Or, PV of leases = 6.83 + 9.52 + 12.07 + 14.50 + 16.79 = $59.71/sqft

Plan B (Lease B);

Lease for the First Year = $7/ sqft

Lease for the Second Year = $0 (since in the second year rent is free)

Lease for the Third Year = $9/sqft

Lease for the Fourth Year = $11/sqft

Lease for the Fifth Year = $13/sqft

Note: since Leases are increasing over $2/sqft per year

Current Market Rate = 2.5%

PV of leases = Lease for the First Year/ (1+ current market rate)^1 + Lease for the second Year/ (1+ current market rate)^2 + Lease for the Third Year/ (1+ current market rate)^3 + Lease for the Fourth Year/ (1+ current market rate)^4 + Lease for the Fifth Year/ (1+ current market rate)^5

Or, PV of leases = 7/ (1.025) + 0/ (1.025) ^2 + 9/ (1.025) ^3 + 11/ (1.025) ^4 + 13/ (1.025) ^5

Or, PV of leases = 6.83 + 0 + 8.36+ 9.96 + 11.49 = $36.64/sqft

Over a period of 5 years Lease B will be cost effective than Lease A, since the PV of Lease of Plan B is < PV of Lease of Plan A.

So the correct option is the last one (Lease B).

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