Question

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?

Answer 1

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.