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 Brussels. The $$9$ million would pay the costs of setting up the new offices,

and the cash flows from the new offices should more than cover the lease payments. And there$$s

no financial risk$$the cash flows from the expansion will cover the lease payments with a safety

cushion. There$$s no reason for you or your partners to worry or to demand a higher$-$than$-$normal

rate of return.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 Brussels. The $$9$ million would pay the costs of setting up the new offices,

and the cash flows from the new offices should more than cover the lease payments. And there$$s

no financial risk$$the cash flows from the expansion will cover the lease payments with a safety

cushion. There$$s no reason for you or your partners to worry or to demand a higher$-$than$-$normal

rate of return.

Q: Construct a simple numerical example to convince Drywall that the lease would expose the

law firm to financial risk. Hint: What is the rate of return on the firm$$s equity investment in

the office building if a recession arrives and the market value of the $($leased$)$ office building falls to $$9$ million after one year? What is the rate of return with conventional mortgage

financing? With all$-$equity financing