Applied Micro Devices (AMD) currently spends

$213,333 a year leasing office space in Austin.

Because lease payments are tax deductible at a 25 percent corporate tax rate, the firm spends about

$160,000 per year [5 $213,333 3 (1 2 .25)] on an after-tax basis to lease the building. The firm has no debt and has an equity beta of 2. Assuming an expected market return of 14 percent and a riskfree rate of 8 percent, its CAPM-based cost of capital is 20 percent. Suppose that AMD has the opportunity to buy its office space for $1 million.

The office building is a relatively risk-free investment. The firm can finance 100 percent of the purchase with tax-deductible mortgage payments. The mortgage rate is only slightly higher than the risk-free rate. How does AMD determine whether to buy the building or continue to lease it?

AppendixLO1