Question

James Kirk is a financial executive with Pharoah Enterprises. Although James Kirk has not had any formal training in finance or accounting, he has a "good sense" for numbers and has helped the company grow from a very small company ($507,000 sales) to a large operation ($45,630,000 in sales). With the business growing steadily, however, the company needs to make a number of difficult financial decisions in which James Kirk feels a little "over his head." He therefore has decided to hire a new employee with "numbers" expertise to help him. As a basis for determining whom to employ, he has decided to ask each prospective employee to prepare answers to questions relating to the following situations he has encountered recently. Here are the questions. Click here to view factor tables In 2019, Pharoah Enterprises negotiated and closed a long-term lease contract for newly constructed truck terminals and freight storage facilities. The buildings were constructed on land owned by the company. On January 1, 2020, Pharoah took possession of the leased property. The 20-year lease is effective for the period January 1, 2020, through December 31, 2036. Advance rental payments of $875,000 are payable to the lessor (owner of facilities) on January 1 of each of the first 10 years of the lease term. Advance payments of $432,000 are due on January 1 for each of the last 10 years of the lease term. Pharoah has an option to purchase all the leased facilities for $1 on December 31, 2036. At the time the lease was negotiated, the fair value of the truck terminals and freight storage facilities was approximately $7,229,000. If the company had borrowed the money to purchase the facilities, it would have had to pay 10% interest. Compute the present value of lease vs purchase. (Round factor values to 5 decimal places, e.g. 1.25124 and final answer to 0 decimal places, e.g. 458,581.) Lease Purchase Present value $ Should the company have purchased rather than leased the facilities? Pharoah Enterprises should the facilities.

Answer 1

  PHAROAH ENTERPRISES :

PRESENT VALUE OF LEASING THE PROPERTY :

Annuity factor of 10% for first 10 years = 1/(1.10)¹⁰ = 6.14457

Annuity factor of 10% for next 10 years = 2.36900

   TOTAL PF VALUE       = 8.51357

Annual lease payment for first 10 years = $ 875,000 *10 Years * AF 6.14457 = $ 53,764,988

Annual lease payment foe next 10 years = $ 432,000 *10 years * AF 2.36900= $ 10,234,080

PRESENT VALUE OF LEASING = $ 63,999,068

PRESENT VALUE OF PURCHASING THE PROPERTY :

Fair value of property = $ 7,229,000

Interest of borrowing = 10 %

Interest for 20 years   =  7,229,000 * 10 % * 20 years

= 14,458,000

Present value of interest = $ 14,458,000 * Total PF value 8.51357

= $ 123,089,195

TOTAL PURCHASE VALUE = $ 7,229,000 + $ 123,089,195 [ principal + interest ]

= $ 130,318,195

COMPARING PURCHASE PRICE AND LEASING PRICE ,

LEASING SEEMS TO BE A BETTER OPTION .