A law firm (not Dewey, Cheatem, and Howe) is expanding rapidly and must move to new office space. Business is good, and the firm is encouraged to purchase an entire building for $10 million.

The building offers first-class office space, is conveniently located near their most important corporate clients, and provides space for future expansion. The firm is considering how to pay for it.

Claxton Drywall, a consultant, encourages the firm not to buy the building but to sign a longterm lease for the building instead. "With lease financing, you'll save $10 million. You won't have to put up any equity investment," Drywall explains.

The senior law partner asks about the terms of the lease. "I've taken the liberty to check," Drywall says. "The lease will provide 100% financing. It will commit you to 20 fixed annual payments of $950,000, with the first payment due immediately."
"The initial payment of $950,000 sounds like a down payment to me," the senior partner observes sourly.

"Good point," Drywall says amiably, "but you'll still save $9,050,000 up front. You can earn a handsome rate of return on that money. For example, I understand you are considering branch offices in London and New Delhi. The $9 million would pay the costs of setting up the new

QUESTIONS

Suppose the present value of the building equals its purchase price of $10 million. Assume that the law firm can finance the offices in London and New Delhi from operating cash flow, with cash left over for the lease payments. The firm will not default on the lease payments. For simplicity you can ignore taxes.

1. If the law firm takes the lease, it will invest $950,000 and, in effect, borrow $9,050,000, repaid by 19 installments of $950,000. What is the interest rate on this disguised loan?

2. The law firm could finance 80% of the purchase price with a conventional mortgage at a 7% interest rate. Is the conventional mortgage better than the lease?

3. Construct a simple numerical example to convince Drywall that the lease would expose the law firm to financial risk.

4. Do the investments in London and New Delhi have anything to do with the decision to finance the office building? Explain briefly.