Introduction

Krueger Mac is a large international property trust, whose prime business is to own and manage office buildings in large financial capitals such as London. With a portfolio of nearly 500 properties/buildings worldwide, Krueger Mac is strategically considering to purchase an office building available for sale in Central London. The sale is expected to be completed at the end of 2015 so that the office building will be available for lease to customers at the beginning of 2016.

Krueger Mac is conducting a financial analysis based on which it will decide whether to purchase this office building or not. The analysis requires predicting the after-tax cash flow (ATCF) resulting from purchasing and operating the building in the next few years. If the after-tax cash flow is negative, Krueger Mac will have paid out more money in principal, interest, operating expenses, and taxes than they received in rent, thus taking a loss on the investment.

Purchase and maintenance costs

The size of the building of interest is 180,000 square feet. A likely price per square foot is assumed to be 270. However, the final price can range between 250 and 300 per square foot according to a market analysis. It is assumed that Krueger Mac has enough cash in hand to purchase this property.

The company must also pay for the cost of operating the building, which includes taxes, insurance, maintenance, and certain utilities. They predict that the average annual operational cost per square foot will be 11.0. Krueger Mac could negotiate good deals with local maintenance companies, which it hopes will cut operational costs to 10 per square foot and per year. If Krueger Mac is lucky, it may even be able to cut them to 8 per square foot and per year. Those maintenance contracts may be signed annually.

Income

The annual rent per square foot is assumed to be within 70 and 100 with an average of 90. But not all offices will be rented out mainly due to economic volatility. Vacancy percentages could range between 10% and 50% with an average of 30%.

Taxation

The net profit that Krueger Mac makes is subject to taxation. Any income under 6,000 is free of tax. The tax rate for any income above 6,000 but less than 15,000 is 20%. The tax rate for any income above 15,000 but less than 30,000 is 40%. The tax rate for any income above 30,000 is 50%. It is assumed that tax rates remain unchanged in the next 10 years. Under these 2assumptions, if Krueger Mac's net income in a year is 45,000, then it has to pay taxes of 15,300.

The financial planning problem

Krueger Mac is preparing a 10-year cash flow model, discounted at a rate of 10%. At the end of the 10 years it expects its total investment to depreciate (due to space use) to 50% of its current value. However, given the volatility in the property market, the depreciation over 10 years may well be anywhere between 30% and 70%.

1) Based on the above information, should Krueger Mac purchase this office building?

2) If Krueger Mac's equity-debt mix is 70:30 (instead of the previous 100:0) with a similar credit risk profile to a firm rated Baa1 by Moody's or equivalent, should it still purchase the office building? You are requested to help Krueger Mac evaluate its purchase plan by producing a 10-year capital budgeting model.

Prepare a business finance report for such a project. (Marking scheme: 20% summary and introduction, 50% analysis and modelling, 30% conclusions and business recommendations). Presentation is also important.

Suggested Tasks (for guidance only):

1) What is the objective of this project?

2) Identify uncertain inputs and the key output performance measure.

3) Describe how you build your model.

4) If you use spreadsheet:

Build a base model for your 10-year cash flow analysis as if all inputs were certain by taking average values.

Discuss sources of uncertainty/risk and run sensitivity analyses.

5) Provide a summary report, including your recommendations. Argue for your recommendations in intuitive terms, backed by key numbers and graphs from your analysis.