Question

Brubaker Inc., a manufacturer of high-sugar, low-sodium, low-cholesterol TV dinners, would like to increase its market share in the Sunbelt. In order to do so, Brubaker has decided to locate a new factory in the Panama City area. Brubaker will either buy or lease a site depending upon which is more advantageous. The site location committee has narrowed down the available sites to the following three buildings. Building A: Purchase for a cash price of $610,000, useful life 25 years. Building B: Lease for 25 years with annual lease payments of $70,000 being made at the beginning of the year. Building C: Purchase for $650,000 cash. This building is larger than needed; however, the excess space can be sublet for 25 years at a net annual rental of $6,000. Rental payments will be received at the end of each year. The Brubaker Inc. has no aversion to being a landlord. In which building would you recommend that Brubaker Inc. locate, assuming a 12% cost of funds? (Show me your work! * Note: Please explain clearly what formula you use to calculate it and write down clearly where do you get the numbers to substitute into the formula.

Answer 1

Present value of cash outflow of each Building :

Building A : $610,000

Building B :

Present value of cash outflows = $70,000(to be paid at beginning of Year 1) + $70,000 * PVAF(12%, 24 years)

Present value = $70,000 + $70,000 * 7.78 = $70,000 + $544,600 = $614,600

Note : 24 years have been taken above since payment is to be made at the beginning of each year

Building C :

Cash outflow today = $650,000

Less : Present value of annual rent = $6,000 * PVAF(12%, 25 years) = $6,000 * 7.84 = $47,040

Present value of cash outflows = $602,960

Note : 25 years have been taken above since payment is to be received at the end of each year.

Final Decision : Since outflow is lowest in case of Building C, I would recommend Brubaker Inc. to locate in this building.

Please Note : PVAF - Present Value Annuity factors can be easily seen from the PVAF table which would be available with the student. If it is not available you can just google the PVAF table or simply PVAF (12%, 25 years).