Question

Managerial Accounting (11th Edition)

14-39

UCUPLU CASE 14-39 Net Present Value Analysis of a Lease or Buy Decision (L01] Top-Quality Stores, Inc., owns a nationwide chain of supermarkets. The company is going to open another store soon, and a suitable building site has been located in an attractive and rapidly grow- ing area. In discussing how the company can acquire the desired building and other facilities needed to open the new store, Sam Watkins, the company's vice president in charge of sales, stated, "I know most of our competitors are starting to lease facilities rather than buy, but I just can't see the economics of it. Our development people tell me that we can buy the building site, put a build- ing on it, and get all the store fixtures we need for just $850,000. They also say that property taxes, insurance, and repairs would run $20,000 a year. When you figure that we plan to keep a site for 18 years, that's a total cost of $1,210,000. But then when you realize that the property will be worth at least a half million in 18 years, that's a net cost to us of only $710,000. What would it cost to lease the property? "I understand that Beneficial Insurance Company is willing to purchase the building site, con- struct a building and install fixtures to our specifications, and then lease the facility to us for 18 years at an annual lease payment of $120,000," replied Lisa Coleman, the company's executive vice president. "That's just my point," said Sam. "At $120,000 a year, it would cost us a cool $2,160,000 over the 18 years. That's three times what it would cost to buy, and what would we have left at the end? Nothing! The building would belong to the insurance company!" "You're overlooking a few things," replied Lisa. “For one thing, the treasurer's office says that we could only afford to put $350,000 down if we buy the property, and then we would have to pay the other $500,000 off over four years at $175,000 a year. So there would be some interest involved on the purchase side that you haven't figured in." "But that little bit of interest is nothing compared to over 2 million bucks for leasing," said Sam. "Also, if we lease I understand we would have to put up an $8,000 security deposit that we wouldn't get back until the end. And besides that, we would still have to pay all the yearly repairs and maintenance costs just like we owned the property. No wonder those insurance companies are so rich if they can swing deals like this." "Well, I'll admit that I don't have all the figures sorted out yet," replied Lisa. "But I do have the operating cost breakdown for the building, which includes $7,500 annually for property taxes, $8,000 for insurance, and $4,500 for repairs and maintenance. If we lease, Beneficial will handle its own insurance costs and of course the owner will have to pay the property taxes. I'll put all this together and see if leasing makes any sense with our required rate of return of 16%. The president wants a presentation and recommendation in the executive committee meeting tomorrow. Let's see, development said the first lease payment would be due now and the remaining ones due in years 1-17. Development also said that this store should generate a net cash inflow that's well above the average for our stores."

Answer 1

1)
Item	Year(s)	Amount of Cash Flows	16% Factor	Present Value of Cash Flows
Purchase of facilities:
Initial payment—property	Now	($350,000)	1	($350,000)
Annual payments—property	1-4	($175,000)	2.798	($489,650)
Annual cash operating costs	1-20	($20,000)	5.818	($116,360)
Resale value of the property	20	$500,000	0.069	$34,500
Net present value				($921,510)
Lease of facilities:
Initial deposit	Now	($8,000)	1	($8,000)
First lease payment	Now	($120,000)	1	($120,000)
Remaining lease payments	1-19	($120,000)	5.749	($689,880)
Annual cost of repairs, etc.	1-20	($4,500)	5.818	($26,181)
Return of deposit	20	$8,000	0.069	$552
Net present value				($843,509)
Net present value in favor of leasing the facilities				$78,001
The problem with Sam Watkin’s approach, in which he simply added up the payments, is that it ignores the time value of money. The purchase option ties up large amounts of funds that could be earning a return elsewhere.
2)
If Sam Watkins brings up the issue of the building’s future sales value, then it should be pointed out that a property that can be sold for $500,000 in 18 years has a present value of only $34,500 if a company can invest money at 16%. In other words, a high future sale value is often worth very little in terms of present value when money can be invested at a high rate of return, such as in the case of Top-Quality Stores.The lease alternative would still be better than the purchase alternative.