Net Present Value Analysis of a Lease or Buy Decision Faster Fashion Stores, Inc., owns a nationwide chain of supermarkets. The company is going to open another store soon, and a suitable building site has been located in an attractive and rapidly growing area. In discussing how the company can acquire the desired building and other facilities needed to open the new store, The Dude Watkins, the company's vice president in charge of sales, stated, I know most of our competitors are starting to lease facilities rather than buy, but I just can't see the economics of it. Our development people tell me that we can buy the building site, put a building on it, and get all the store fixtures we need for just $850,000. They also say that property taxes, insurance, and repairs would run $20,000 a year. When you figure that we plan to keep a site for 18 years, that's a total cost of $1,210,000. But then when you realize that the property will be worth at least a half million in 18 years, that's a net cost to us of only $710,000. What would it cost to lease the property? I understand that Grate Insurance Company is willing to purchase the building site, construct a building and install fixtures to our specifications, and then lease the facility to us for 18 years at an annual lease payment of $120,000, replied Wage Garnisher Coleman, the company's executive vice president. That's just my point, said The Dude. At $120,000 a year, it would cost us a cool $2,160,000 over the 18 years. That's three times what it would cost to buy, and what would we have left at the end? Nothing! The building would belong to the insurance company! You're overlooking a few things, replied Wage Garnisher. For one thing, the treasurer's office says that we could only afford to put $350,000 down if we buy the property, and then we would have to pay the other $500,000 off over four years at $175,000 a year. So there would be some interest involved on the purchase side that you haven't figured in. But that little bit of interest is nothing compared to over 2 million bucks for leasing, said The Dude. Also, if we lease I understand we would have to put up an $8,000 security deposit that we wouldn't get back until the end. And besides that, we would still have to pay all the yearly repairs and maintenance costs just like we owned the property. No wonder those insurance companies are so rich if they can swing deals like this. Well, I'll admit that I don't have all the figures sorted out yet, replied Wage Garnisher. But I do have the operating cost breakdown for the building, which includes $7,500 annually for property taxes, $8,000 for insurance, and $4,500 for repairs and maintenance. If we lease, Grate will handle its own insurance costs and of course the owner will have to pay the property taxes. I'll put all this together and see if leasing makes any sense with our required rate of return of 16%. The president wants a presentation and recommendation in the executive committee meeting tomorrow. Let's see, development said the first lease payment would be due now and the remaining ones due in years 117. Development also said that this store should generate a net cash inflow that's well above the average for our stores. Required: (Ignore income taxes.) 1 Using the net present value approach, determine whether Faster Fashion Stores, Inc., should lease or buy the new facility. Assume that you will be making your presentation before the company's executive committee. 2 How will you reply in the meeting if The Dude Watkins brings up the issue of the building's future sales value? Cash Flow Description Cash Flows Amounts to choose from Periods to choose from Store Site Cost 850,000.00 1 Annual Property Taxes 7,500.00 1 through 18 Annual Insurance Cost 8,000.00 1 through 4 Annual Repairs 4,500.00 18 Annual Property Taxes, Insurance, and Repairs 20,000.00 2 Site Salvage Value 500,000.00 3 Annual Lease Payments 120,000.00 4 Loan Downpayment 350,000.00 1 through 17 Annual Loan Payments 175,000.00 0 Life of the Loan (Years) 4.00 17 Life of the Store (Years) 18.00 Lease Security Deposit 8,000.00 Required Rate of Return 16.00% To Buy Period Cash Flow Description Cash Flow Amount Cash Flow Present Value Net Present Value To Lease Period Cash Flow Description Cash Flow Amount Cash Flow Present Value Net Present Value