Arpeggio Music Company owns two buildings and rents its remaining stores. The two owned buildings are located next to each other on a single lot. The first building (called the "Main Store") was custom built in 1962 by the company and houses studio space, storage space for instruments and accessories, sheet music display and storage, offices, and the instrument showroom. The company paid $40,000 for the land and custom building in 1962. In 1979, AMC worked with an architect on an expansion plan for the Main Store. The architectural plans cost $10,000 but the company did not move forward with the expansion because they did not receive approval from the city planning board. The addition would not have left enough parking space for a commercial building. Expansion plans languished until 1995 when AMC purchased the adjacent lot and the 100-year old house on it for $80,000 cash. The house was rezoned from residential tocommercial use and the two lots were combined into one. The house was then retrofitted for additional music studios and practice rooms, the instrument repair shop, sheet music display cases, and a small space used as a museum to house Joe Trazinski's antique instrument collection, valued at about $70,000. The company spent $80,000 on legal fees and retrofitting when it acquired the house.

AMC's business activities in these two buildings have been stagnant in recent years and the company feels that it can consolidate the activities into the Main Store building, split the lot, and sell the house. The managers are hesitating, however, because they believe that commercial real estate prices are rising by 5% per year. In addition, several real estate agents have told them that the lot may be more valuable in one piece in the future (lots this size are difficult to find in the neighborhood) and estimate up to a 20% premium because of the size. The estimate of the current value of the house alone (and zoned for commercial use) is $150,000. The estimate of the current value of the Main Store alone is $100,000.

Both buildings are paid for, but the company pays substantial property taxes. If the lot was split, they estimate that the property tax on the remaining piece would be half the amount. They do have the concern that in a few years the air-conditioning unit in the house will give out. The estimated cost to replace it is $10,000. The company is looking at a five-year time horizon: if they don't sell now, they expect to sell this property in five years and move to a different neighborhood that is closer to their key client base. It is possible that they will consolidate with one or more of the other stores, but this picture will be clearer in the coming years.

If AMC does sell the house, Joe would consider selling the antique instrument collection at that point in time. If they don't sell the house, Joe would probably move the collection to another store when all the activities are moved in five years.

They are considering requesting rezoning for the house for mixed usage (commercial and residential) but they are fairly sure that necessary fire-safety improvements would be extremely costly and that the market value would not be much greater. Rezoning in this way would probably simply make the house appealing to a wider range of buyers.

The company managers think that there will be no other costs apart from those described above and below. On the other hand, selling the house may signal that the company is in trouble and may cause customers to look elsewhere for their educationalmusic needs. They estimate that this could cause lost sales of up to $10,000 per year.

Joe Trazinski understands that the only costs related to splitting the lot are legal and surveyor fees. He is concerned, however, about the time required to follow up on this and in particular, thework with the planning board.

The company has been told by its accountant that 8% would be an appropriate rate of return expected for a project such as this one.

Unless otherwise indicated, assume that operating expenses are split 50/50 between the two buildings and that 50% of the costs are avoidable if a building is sold.

Information on the various costs:

Estimated surveyor and legal costs to split the lot: $2000

Property taxes: $11,000 per year

Insurance: $2000 for one three-year policy on both buildings that cannot be re-negotiated. In three years time AMC can buy a new policy.

Maintenance: $8000 per year

Snow removal: $3000 per year

Additional information:

1. Assume that there will be no changes to the staff, regardless of the decision.

2. Assume no changes to working capital, regardless of the decision.

3. For simplicity, ignore any income taxes.

4. The Main Store has been fully depreciated. The house is being straight line depreciated over 40 years.

5. Joe Trazinski uses the house as a personal storage space. If the house is sold, he would have to clean up his boxes and move them somewhere else. This may entail renting storage space.

The city planning board meets once per month so AMC needs to get moving on a decision in the event they do want to put the house on the market. If they make a decision quickly and putthe house on the market, they do expect to sell it within the next few months.

Case questions:

1. Arpeggio management does not have a very good understanding the time value of money, sunk costs, or relevant costs. Explain the decisions at hand using these terms.

2. AMC management knows that they will have to spend substantial time on this project either right away or in five years time. How would you help them understand and possibly quantify the time involved now versus the time involved five years in the future?

3. AMC's accountant has warned them about being too optimistic on real estate prices. She suggests assuming a 2% appreciation over the coming five years. She is also concerned about the assumption of a 20% premium for the size of the lot. Build a scenario analysis for AMC incorporating these concerns.

4. What comments or recommendations can you make on the estimate of lost sales?

5. What should Arpeggio do? Clearly support your recommendation.

6. Is there another alternative if AMC is short on cash?