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. "T've already checked that," Rooney says. The lease will provide 100% financing. It will commit yeu 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 willl 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.

Answer 1

Answer 1

By taking it on a lease, it means you are raising debt of $ 10 million with an interest rate of 8%. It is better to finance through equity rather than paying interest. The return on equity saved by not buying the land should be greater than 8%.

If recession hits and the value of the land goes below let's suppose $ 8 million, the rate of interest which the firm would be paying would be equivalent to 12% and the money you saved as equity by not investing upfront ie. $ 10 million should give you a return of 12% to make up for the loss.

$10 million = Σ 950000/((1+R)^N)

The rate of interest with a conventional mortgage scheme is 8%.

Answer 2

Investment in London and Beijing is very different from any investment made in financing the current building as we have to look at their cost, their funding source, and the viability of the project. The evaluation of them should be done as a separate projects with their project's return based on the various risk factors involved factoring in different country risks and things like that.