Problem #3 (10 points)

The ABC Corporation is considering opening an office in a new market area that would allow it to increase its annual sales by $2.5 million. Cost of goods sold is estimated to be 40 percent of sales, and corporate overhead would increase by $300,000, not including the cost of either acquiring or leasing office space. The corporation will have to invest $2.5 million in office furniture, office equipment, and other up-front costs associated with opening the new office before considering the costs of owning or leasing the office space.

A small office building could be purchased for sole use by the corporation at a total price of $3.9 million, of which $600,000 of the purchase price would represent land value, and $3.3 million would represent building value. The cost of the building would be depreciated over 39 years. The corporation is in a 30 percent tax bracket. An investor is willing to purchase the same building and lease it to the corporation for $450,000 per year for a term of 15 years, with the corporation paying all real estate operating expenses (absolute net lease). Real estate operating expenses are estimated to be 50 percent of the lease payments.

Estimates are that the property value will increase over the 15-year lease term for a sale price of $4.9 million at the end of the 15 years. If the property is purchased, it would be financed with an interest-only mortgage loan for $2,730,000 at an interest rate of 10 percent with a balloon payment due after 15 years.

a. Calculate the ABC Corporations after-tax IRR from opening the office building under the assumption that it is leased. Show and explain all calculations.

b. Calculate the ABC Corporations after-tax IRR from opening the office building under the assumption that it is owned. Show and explain all calculations.

c. Calculate the ABC Corporations after-tax IRR on the incremental cash flow from owning rather than leasing. Show and explain all calculations. Explain how this number would help the company make the owning versus leasing decision.