Reds Company owns a building in a suburban industrial park. It purchased the building four years ago
Question:
Reds Company owns a building in a suburban industrial park. It purchased the building four years ago for $3 million. It is now deciding whether to lease the building or to use it as a distribution center. It could be rented immediately. Given today’s market conditions, rental income of $120,000 per year would be expected. To convert the building to make it useful as a distribution center would require an immediate expenditure of $400,000. Having the distribution center at this location would provide Reds with $140,000 per year in cost savings, at today’s prices. The cash flows associated with this decision are not very risky, so a real discount rate of just 3% per year is required. Inflation of 2% per year is expected in the future. For simplicity, assume that: (i) there are no taxes, (ii) the building could be rented or used as a distribution center forever, (iii) ongoing cash flows, including rents and distribution cost savings, would increase with the overall inflation rate, and (iv) all cash flows except the initial $400,000 would occur at year end. (the last assumption implies that one year of inflation would affect the first lease payment and distribution cost saving)
(a)Provide a NPV analysis and a recommendation of how the building should be used.
(b)Is the outcome of your NPV analysis sensitive to changes in the assumed inflation rate?
Engineering Economy
ISBN: 978-0133439274
16th edition
Authors: William G. Sullivan, Elin M. Wicks, C. Patrick Koelling