Question

Ekea Company is building a warehouse which is no longer needed now. The warehouse is 90% completed and can be sold for $90,000, which is the cost incurred on the warehouse to date.

If it is sold, Ekea would have to pay the property agent a commission of 1% on sale and the buyer of the warehouse would have to complete the building of the warehouse.

Alternatively, the completed warehouse can be leased for a period of 5 years at $15,000 per year. At the end of the lease, the warehouse could then be sold for $70,000. The completed warehouse would cost a total of $100,000 to build, and will be depreciated over 10 years on straight-line basis.

If the warehouse is to be leased for the 5-year period, Ekea (the lessor) must obtain a permit, which will cost $3,000 per year. The lessee would have to be responsible for the repairs and maintenance of the warehouse, estimated to be $25,000, for the period of the lease.

Required:

1. Identify and explain which items are relevant and which are irrelevant.
2. Ignoring qualitative factors and the time value of money, should Ekea sell the partially completed warehouse or complete the construction and lease it out? Use differential analysis to help you make your decision.
3. What two qualitative factors need to be considered before making a decision?

Answer 1

a) i) Cost of completing the property i.e $ 10,000 is irrelevant as it will be incurred in both the alternatives i.e lease or sale the property

ii) Depreciation on property as tax rates are not provided therefore tax benefit cannot be calculated

B)

Particulars	Lease Building	Sell Building	Differential
	(Alternative 1)	(Alternative 2)
Cash Inflow
Cash Inflow (Lease rentals)	75,000	-	75,000
Total			75,000
Cash Outflow
Commision( 1% of sale)	700	900	(200)
Permit Cost	15,000	-	15,000
Repair and Maintance	25,000	-	25,000
Loss on sale of property	30,000	10,000	20,000
Total			59,800
		Total Cash inflow	15,200

as per differntial approch the property need to be leased

c) Qualtiative factors need to considered before making decsion

1- Cash flow: A business can conserve its cash flow by leasing. Under a lease, the initial cashflow income can be further used to gain the interest income .

2- Tax savings - Depreciating the property over time may bring you tax savings. In addition, if the property is financed, interest based deductions are available