Practice Problem #54 FIN-335 Entrepreneurial Finance - Leasing v. Purchase Decision Purchase Scenario: Annie is trying to decide whether she should Lease or Purchase a commercial building for the next five years. Assuming that it was purchased for $100,000 plus $3,000 in closing costs the initial cash investment (equity) will be $28,000. The balance can be financed with a $75,000, 9.5%, 20-year mortgage. Likewise, is the fact that the building's depreciable value is $83,000 with a 31% marginal tax rate. Operation and Maintenance (O&M) for Year 1 equates to $3,500; estimated to increase 3% annually. In Annie's case specifically, annual operation and maintenance costs, depreciation, and interest are tax deductible. Thus, annual cash outflow associated with purchasing the building is the sum of O&M costs plus mortgage payment(s) minus deductible expense tax-shielding. Leasing Scenario: For the sake of an appropriate five-year lease comparison, assume that the property will be sold at the end of the fifth year. Estimate the after-tax cash flow from resale. For clarity, the property's estimated resale price at the end of Year 5 is $116,000; estimated after-tax cash flow from resale is $33,454 respectively. Leased for five years, where annual lease payments are due in advance, the first year's lease payment is $10,000. The following year's lease payments are scheduled to increase 3% annually. The tenant will pay all annual operating expenses; same as if the building is purchased. This in mind, and because the lease payments and the operating expenses are tax deductible, after-tax cost of leasing is the sum of the lease payment plus O&M costs minus the tax-shielding provided by the deductible expenses. #54 Cont. Based on the information presented, should Annie's business lease or purchase the commercial building. Support your decision by calculations and appropriate cash flow diagrams. Please also answer the following questions: 54a) Determine Annie's present value cost of owing. 54b) Determine Annie's present value cost of leasing. 54c) What is the net advantage of leasing if Annie were to choose this route? Practice Problem #54 FIN-335 Entrepreneurial Finance - Leasing v. Purchase Decision Purchase Scenario: Annie is trying to decide whether she should Lease or Purchase a commercial building for the next five years. Assuming that it was purchased for $100,000 plus $3,000 in closing costs the initial cash investment (equity) will be $28,000. The balance can be financed with a $75,000, 9.5%, 20-year mortgage. Likewise, is the fact that the building's depreciable value is $83,000 with a 31% marginal tax rate. Operation and Maintenance (O&M) for Year 1 equates to $3,500; estimated to increase 3% annually. In Annie's case specifically, annual operation and maintenance costs, depreciation, and interest are tax deductible. Thus, annual cash outflow associated with purchasing the building is the sum of O&M costs plus mortgage payment(s) minus deductible expense tax-shielding. Leasing Scenario: For the sake of an appropriate five-year lease comparison, assume that the property will be sold at the end of the fifth year. Estimate the after-tax cash flow from resale. For clarity, the property's estimated resale price at the end of Year 5 is $116,000; estimated after-tax cash flow from resale is $33,454 respectively. Leased for five years, where annual lease payments are due in advance, the first year's lease payment is $10,000. The following year's lease payments are scheduled to increase 3% annually. The tenant will pay all annual operating expenses; same as if the building is purchased. This in mind, and because the lease payments and the operating expenses are tax deductible, after-tax cost of leasing is the sum of the lease payment plus O&M costs minus the tax-shielding provided by the deductible expenses. #54 Cont. Based on the information presented, should Annie's business lease or purchase the commercial building. Support your decision by calculations and appropriate cash flow diagrams. Please also answer the following questions: 54a) Determine Annie's present value cost of owing. 54b) Determine Annie's present value cost of leasing. 54c) What is the net advantage of leasing if Annie were to choose this route
