Question

A law firm is expanding rapidly and must move to new office space. Business is good, and the firm is encouraged to purchase an entire building for £10 million. The building offers first-class office space, is conveniently located near their most important corporate clients, and provides space for future expansion. The firm is considering how to pay for it. David Rooney, a consultant, encourages the firm not to buy the building but to sign a long- term lease instead. “With lease financing, you’ll save £10 million. You won’t have to put up any equity investment,” Rooney explains. The senior law partner asks about the terms of the lease. “I’ve already checked that,” Rooney says. “The lease will provide 100% financing. It will commit you to 20 fixed annual payments of £950,000, with the first payment due immediately.” “The initial payment of £950,000 sounds like a down payment to me,” the senior partner observes sourly. “Good point,” Rooney says amiably, “but you’ll still save £9,050,000 up front. You can earn a good rate of return on that money. For example, I understand you are considering branch offices in London and Beijing. The £9 million would pay the costs of setting up the new offices, and the cash flows from the new offices should more than cover the lease payments. And there is no financial risk—the cash flows from the expansion will cover the lease payments with a safety cushion. There is no reason for you or your partners to worry or to demand a higher-than-normal rate of return.”

Requirement: Suppose the present value of the building equals its purchase price of £10 million. Assume that the law firm can finance the offices in London and Beijing from operating cash flow, with cash left over used for the lease payments. The firm will not default on the lease payments. For simplicity, you may ignore taxes.

(a)If the law firm takes the lease, it will invest £950,000 and in effect borrow £9,050,000, repaid by 19 instalments of £950,000. What is the interest rate on this disguised loan? [20 marks]

(b)The law firm could finance 80% of the purchase price with a conventional mortgage at a 7% interest rate. Is the conventional mortgage better than the lease? Provide supporting calculations and discussion. [20 marks]

(c)Construct a simple numerical example to convince Rooney that the lease would expose the law firm to financial risk. You may wish to consider what is the rate of return on the firm’s equity investment in the office building if a recession arrives and the market value of the (leased) office building falls to £9 million after one year?; what is the rate of return with conventional mortgage financing?; with all-equity financing? [15 marks]

(d)Do the investments in London and Beijing have anything to do with the decision to finance the office building? Explain briefly. [10 marks]

Answer 1

Jolution in entire building The firm is encouraged to purchase an for flo millions a) The law firm takes the lease, it will invest £950,000 Ein effect borrow £ 9,050,000, r@paid by la instaiments of £450,000. interest rate on this disquised loan. - parating the pus, using the py of annuity due formula for 20 annual payment of 950000 : - The interest rate on the rease 8.114 Total Cash out from onder lease will be ... 950000* 20 19.00.0000 . bi law firm Covid Could finance 80%. Of the purchase price with a conventional mortgage at a 77. interest yote. better than the → Is the Conventional mostage bette lease -> 80%* 10.000000 - 8,000,000 is financed die .

00 -> monthly payment on the mortgagem Taking monthly Tate = Taking -0.005833 X100 -0.5834. Monthly payment . So, total yearly payment : 62022*12 74, 264 Total Cash out flow Onder mortgage will be >> (62022.*12* 20)+ (2000.000) = 144,885,280 + 2,000,000 => 16,885,280 : : so, Conventional mortage is cheaper than leasing Leading will expose the firm to financial riske * the market value of the leased building fatis from 10 millions to a millions. * Under Conventional mortgage, the firm can deduct periodic mollage Payment towards interest, & also toosids interest, & also Claim depreciation for the buildings Archased.

* The law firm stands to lose by way of higher annual lease payments. Calculated based on the original price. which affect the net income e consequent return to share holder's eanity.. * As interest payments are less under mortage, it Creates more return to eauity.