Tip Top Canadian Inc owns a nationwide chain of supermarkets.
The company plans to open another in Montreal, Quebec. In
discussion about how the company can acquire the desire building
and other facilities need to open the new store, Tony Wong, 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 developments
people tell us that we can buy the building site, put a building on
it, and get all the store fixtures that we need for just
$1,000,000. They also say that property taxes, insurance, and
repairs would run $25,000 a year. When you figure that we plan to
keep a site for 20 years, that is a total cost of $1,500,000, but
when you realize that the property will be worth at least $600,000
in 20 years, that’s a net cost to us of only
$900,000. What would it cost to lease the property?”
“I understand that Manulife Insurance Company is willing to
purchase the building site, construct the building, install the
fixtures to our specifications and then lease the facility to us
for 20 years at an annual lease payment of $125,000,” replied Brett
Cranston, the company’s executive vice-president.
“That’s just my point,” said Tony. “At $125,000 a year, it would
cost us a cool $2,500,000 over the 20 years. That’s close to three
times what it would have cost to buy, and what would we have left
at the end? Nothing! The building would belong to the insurance
company!”
“You are overlooking a few things,” replied Brett. “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 $700,000 off over seven years at 100,000 per 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 with $2.5
million bucks for leasing,” said Tony. “Also if we lease, I
understand we would have to put up a $200,000 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 cost 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 I don’t have all the figures sorted out yet,”
replied Tony. “But I do have all the operating costs break down for
the building, which includes $40,000 annually for property taxes,
$12,000 annually for insurance cost and $6,000 annually for repairs
and maintenance. If we lease Manulife will handle its own insurance
costs, and of course, the owner will have to pay the property
taxes. I’ll put all this together and see if leasing makes any
sense with our own required rate of return of 16%. The president
wants a presentation and a recommendation in the executive
committee meeting tomorrow. Let’s see, Development said the first
lease payment would be due now and the remaining due years 1
through 19. Development department also said that this store should
generate a net cash inflow that’s well above the average for our
stores in Ontario.”
Required:
1. Using NPV approach, determine whether Tip Top Inc should lease
or buy the new facility. Assume that you will be making your
presentation before the company’s executive committee, and remember
that the president detests sloppy, disorganized reports.
2. What response will you give in the meeting if Tony brings up the
issue of the buildings future sales value?
1… |
NPV of purchase/buy= |
Initial cost+PV of sum of property taxes,insurance & Rep.& maint. For 20 yrs.+PV of sale value at end of 20 yrs. |
ie. -1000000-((40000+12000+6000)*5.92884)+(600000*0.05139)= |
-1313039 |
NPV of lease= |
Initial security deposit+ PV of annual lease payments for 20 yrs.+PV of rep.& maint.costs for 20 yrs.+PV of Return of security deposit at end of 20 yrs. |
ie.-200000 -(125000*5.92884)-(6000*5.92884)+(200000*0.05139)= |
-966400 |
P/A,i=16%,n=20 yrs---5.92884 |
P/F,i=16%,n=Yr. 20 --0.05139 |
From the above, LEASING is recommended as it is cheaper. |
It is to be noted that ,we need to attach time value to money and cannot treat moneys occurring in different periods on the time scale , to have the same value.It needs to be discounted at the required rate of return, taken as 16%. So all numericals , unless occurring in Year 0, need to be discounted at the appropriate time value . |
Interest on money to be borrowed for the "buy"decision , ie.$ 1000000- $ 350000= $ 650000 ,need to be considered only as cash outflow saved because of interest payments ,on the same.As tax rate is not given here, it is not considered for calculating the NPV of the option. |
2. What response will you give in the meeting if Tony brings up the issue of the buildings future sales value? |
Here, the exact cash flow that will be available at end of 20 yrs. can be best assessed, only if details regarding--the annual depreciation on buildings for 20 years and the accumulated depreciation upto that time of sale as well as the tax rate ,to assess the tax outflow saved or to be incurred ----are known. |
The response will be on the above lines. |
Tip Top Canadian Inc owns a nationwide chain of supermarkets. The company plans to open another...
1. Using NPV approach, determine whether Tip Top Inc should
lease or buy the new facility. Assume that you will be making your
presentation before the company’s executive committee, and remember
that the president detests sloppy, disorganized reports.
2. What response will you give in the meeting if Tony brings up
the issue of the buildings future sales value?
Tip Top Canadian Inc owns a nationwide chain of supermarkets. The company plans to open another in Montreal, Quebec. In discussion...
Managerial Accounting (11th Edition)
14-39
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