A company is planning to move to a larger office and is trying to decide if the new office should be owned or leased. Cash flows for owning versus leasing are estimated as follows. Assume that the cash flows from operations will remain level over a 10-year holding period. If purchased, the company will make an equity investment and finance the remainder with an interest-only loan that has a balloon payment due in year 10. The companys marginal income tax rate is 30% and the after-tax cash flow from sale of the property at the end of year 10 is expected to be $800,000. What would the initial equity investment have to be to generate a 15% incremental rate of return on equity with owning instead of leasing?

8.7.3

Own 800,000 350,000 450,000 Lease 800,000 350,000 450,000 Sales Cost of goods sold Gross income Operating expenses: Business Real Estate Lease payments Interest Depreciation Taxable income Tax Income after tax Plus: Depreciation After-tax cash flow 85,000 45,000 125,000 0 0 85,000 45,000 0 60,000 40,000 220,000 66,000 154,000 40,000 194,000 195,000 58,500 136,500 0 136,500 Own 800,000 350,000 450,000 Lease 800,000 350,000 450,000 Sales Cost of goods sold Gross income Operating expenses: Business Real Estate Lease payments Interest Depreciation Taxable income Tax Income after tax Plus: Depreciation After-tax cash flow 85,000 45,000 125,000 0 0 85,000 45,000 0 60,000 40,000 220,000 66,000 154,000 40,000 194,000 195,000 58,500 136,500 0 136,500