Raul Martinas, professor of languages at Eastern University, owns a small office building adjacent to the university campus. He acquired the property 10 years ago at a total cost of $530,000—$50,000 for the land and $480,000 for the building. He has just received an offer from a realty company that wants to purchase the property; however, the property has been a good source of income over the years, so Professor Martinas is unsure whether he should keep it or sell it. His alternatives are:

Alternative 1: 

Keep the property. Professor Martinas’ accountant has kept careful records of the income realized from the property over the past 10 years. These records indicate the following annual revenues and expenses:

Professor Martinas makes a $12,000 mortgage payment each year on the property. The mortgage will be paid off in eight more years. He has been depreciating the building by the straight-line method, assuming a salvage value of $80,000 for the building which he still thinks is an appropriate figure. He feels sure that the building can be rented for another 15 years. He also feels sure that 15 years from now the land will be worth three times what he paid for it.

Alternative 2: 

Sell the property. A realty company has offered to purchase the property by paying $175,000 immediately and $26,500 per year for the next 15 years. Control of the property would go to the realty company immediately. To sell the property, Professor Martinas would need to pay the mortgage off, which could be done by making a lump-sum payment of $90,000.

Required:

Assume that Professor Martinas requires a 12% rate of return. Would you recommend he keep or sell the property? Show computations using the total-cost approach to net present value.

Transcribed Image Text:

Rental receipts S140,000 Less building expenses: Utilities $25,000 Depreciation of building 16,000 Property taxes and insurance 18,000 9,000 Repairs and maintenance Custodial help and supplies 40,000 108,000 S 32,000 Net operating income