*Show in excel- I included correct answers as I keep receiving incorrect answers.

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. The 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 $4.5 million, of which $900,000 of the purchase price would represent land value, and $3.6 million would represent building value. The cost of the building would be depreciated over 39 years. The corporation is in a 21 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 $5.0 million at the end of the 15 years. If the property is purchased, it would be financed with an interest-only mortgage for $3,150,000 at an interest rate of 4.5 percent with a balloon payment due after 15 years.

Required:

a. What is the return from opening the office building under the assumption that it is leased?

b. What is the return from opening the office building under the assumption that it is owned?

c. What is the return on the incremental cash flow from owning versus leasing?

Explanation

ASSUMPTIONS:

Increase in sales	2,500,000
Costs of goods sold	1,000,000
Increase in corporate overhead	300,000
Personal property	2,500,000
Tax rate	21.00%

LEASE
Annual lease payment	450,000
Lease term	15
Operating expenses	225,000

PURCHASE
Purchase price	4,500,000
Land	900,000
Building	3,600,000
Depreciable life	39
Resale value	5,000,000
Interest-only loan:
Amount	3,150,000
Interest rate	4.50%

	Own	Lease	Difference (Own-Lease)
Sales	$ 2,500,000	$ 2,500,000	$ 0
Costs of goods sold	1,000,000	1,000,000	0
Gross income	1,500,000	1,500,000	0
Operating expenses:			0
Business	300,000	300,000	0
Real estate	225,000	225,000	0
Lease payments	0	450,000	(450,000)
Interest	141,750	0	141,750
Depreciation	92,308	0	92,308
Taxable income	740,942	525,000	215,942
Tax	155,598	110,250	45,348
Income after tax	585,344	414,750	170,594
Plus: Depreciation	92,308	0	92,308
Plus: Principal	0	0	0
After-tax cash flow	677,652	414,750	262,902

Cash flow from sale - owning

Resale		$ 5,000,000
Mortgage balance		3,150,000
Resale	$ 5,000,000
Basis	3,115,385
Gain	1,884,615
Tax		395,769
After-tax cash flow		1,454,231

Incremental analysis owning vs. leasing

	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7	Year 8	Year 9	Year 10	Year 11	Year 12	Year 13	Year 14	Year 15
Own	(3,850,000)	677,652	677,652	677,652	677,652	677,652	677,652	677,652	677,652	677,652	677,652	677,652	677,652	677,652	677,652	2,131,883
Lease	(2,500,000)	414,750	414,750	414,750	414,750	414,750	414,750	414,750	414,750	414,750	414,750	414,750	414,750	414,750	414,750	414,750
Difference	(1,350,000)	262,902	262,902	262,902	262,902	262,902	262,902	262,902	262,902	262,902	262,902	262,902	262,902	262,902	262,902	1,717,133

a.

ATIRR (lease): 14.38%

b.

ATIRR (own): 16.44%

c.

ATIRR (owning vs. leasing difference): 19.59%