Question

Problem 6-9 James Kirk is a financial executive with Flounder 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 ($540,000 sales) to a large operation ($48,600,000 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, Flounder 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, Flounder took possession of the leased property. The 20-year lease is effective for the period January 1, 2020, through December 31, 2039. Advance rental payments of $876,000 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 $407,000 are due on January 1 for each of the last 10 years of the lease term. Flounder has an option to purchase all the leased facilities for $1 on December 31, 2039. At the time the lease was negotiated, the fair value of the truck terminals and freight storage facilities was approximately $7,568,000. If the company had borrowed the money to purchase the facilities, it would have had to pay 9% 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? Flounder Enterprises should the facilities.

Answer 1

Lease vs purchase:
Discount rate=9%
Present value of lease:
Year	Cash flow	PV factor at 9%	Present value
	a	b	a*b
1 to 10	876000	6.99525	6127839
11 to 20	407000	2.95487	1202632.09
Total			7330471.09
Note:
Advance rental payments are made.
Hence,rent is paiod at the beginning of year
So,while calculating PV factor take year 1 as PV factor as 0.
Then compute PV annuity factor for 19 years
PV factor for 1 to 10=1+PV annutiy factor for 9 years
PV factor for 11 to 20=1+PV annutiy from 10 to 19 year
Present value of purchase:
Year	Particulars			Cash flow	PV factor at 9%	Present value
				a	b	a*b
0	Fair value			7568000	1	7568000
1 to 20.	Interest on borrowing		(7568000*9%)
	(PV annuity factor for 20 years)			681120	9.12855	6217638
Total						13785638
Present value of lease is less compared to present value of purchase
Hence,Flounder enterprise should Lease the facilities
Fair value of the note=16500*PV annuity factor at 12% for 8 years=16500*4.96764=$ 81966
Cost of credit=Discount %/(100-Discount %)*(360/Allowed payment days-Discount days)
Cost of credit=1%/(100-1%)*(360/40-10)=(1/99)*(360/30)=0.1212=12.12%
Cost of funds=9%
Cost of credit > Cost of funds
Hence, flounder should not continue the policy