Question

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 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."

Answer 1

Option 1: PURCHASE Cost of Total Cash Flows Property Taxes Insurance Repairs DR @ 16% Year NPV Asset 3,50,000 0 3,50,000 1.00000 3,50,000 1,36,207 0.86207 1,00,000 40,000 12,000 6,000 1,58,000 2. 1,00,000 40,000 12,000 6,000 1,58,000 0.74316 1,17,420 40,000 40,000 40,000 3 1,00,000 12,000 6,000 1,58,000 0.64066 1,01,224 4 1,00,000 12,000 6,000 1,58,000 0.55229 87,262 0.47611 75,226 5 1,00,000 12,000 12,000 12,000 6,000 1,58,000 1,00,000 0.41044 6 40,000 40,000 40,000 6,000 6,000 6,000 6,000 1,58,000 64,850 55,905 7 1,00,000 1,58,000 0.35383 12,000 58,000 0.30503 17,691 40,000 15,251 13,148 9 12,000 58,000 0.26295 6,000 10 40,000 12,000 58,000 0.22668 40,000 6,000 11 12,000 58,000 0.19542 11,334 9,771 0.16846 12. 40,000 12,000 6,000 58,000 40,000 6,000 8,423 13 12,000 58,000 0.14523 6,000 14 40,000 12,000 58,000 0.12520 7,261 40,000 6,000 6,260 15 12,000 58,000 0.10793 12,000 6,000 5,396 16 40,000 58,000 0.09304 6,000 58,000 58,000 17 40,000 12,000 0.08021 4,652 6,000 0.06914 18 40,000 12,000 4,010 0.05961 19 40,000 12,000 6,000 58,000 3,457 -27,851 20 -6,00,000 40,000 12,000 6,000 -5,42,000 0.05139 Total 10,66,898

Option 2: LEASE Total Cash Lease Security Year Repairs DR @ 16% NPV Rentals Flows Deposit 1.00000 0 1,25,000 2,00,000 3,25,000 3,25,000 0.862071,12,931 1 1,25,000 6,000 1,31,000 1,25,000 1,31,000 2. 6,000 0.74316 97,354 3 1,25,000 6,000 1,31,000 1,31,000 0.64066 83,926 1,25,000 4 6,000 0.55229 72,350 5 1,25,000 6,000 1,31,000 1,31,000 0.47611 62,371 0.41044 6 1,25,000 6,000 53,768 6,000 7 1,25,000 1,31,000 0.35383 46,352 6,000 0.30503 1,25,000 1,31,000 39,958 1,25,000 6,000 1,31,000 0.26295 34,447 6,000 0.22668 10 1,25,000 1,31,000 1,31,000 29,696 0.19542 11 1,25,000 6,000 25,600 0.16846 6,000 12. 1,25,000 1,31,000 22,069 1,25,000 13 6,000 1,31,000 0.14523 19,025 1,25,000 6,000 14 1,31,000 0.12520 16,401 15 1,25,000 6,000 1,31,000 0.10793 14,138 0.09304 6,000 12,188 16 1,25,000 1,31,000 17 1,25,000 6,000 1,31,000 0.08021 10,507 0.06914 9,058 18 1,25,000 6,000 1,31,000 1,31,000 0.05961 7,809 19 1,25,000 6,000 9,969 20 2,00,000 6,000 -1,94,000 0.05139 Total 10,84,978 LO

Decision Tip Top Inc should purchase the property due to net benefit of $18,080 (10,84,978 - $10,66,898) If Tony brings up issue of Building Future Salvage Value, we have to consider the below 2 calculations What would be the break-even value of Building Salvage Value, so that Tip Top will be in Indifferent Position Net Benefit due to Buy over lease 18,080 divided by Discount Factor @ 16%, 20th Year 0.05139 3,51,851 If our salvage value declines by $,351,851 i.e, Salvage Value is S2,48,149 ($600,000- S3,51,851), we will be in a indifferent position Decision based on the below Range: Salvage Value Less than $ 248,149 Equal to $248149 Higher than $248149 Decision Lease Indifferent Position Buy