Slide 9-18
This problem is on Chapter 15. Help this turkey figure out which of the below are FALSE: Click on ALL that are FALSE! Do not try to click on all! Negative points will be given for any incorrectly clicked answers. In the problem on slides 9-18, if instead the loan was a 15-year fixed-rate amortizing loan, the ATIRR would be lower. In the problem on slides 9-18, if instead one wanted to calculate the ATIRR based on LEASE-rather-than-buy cash flows, then one would instead conclude that it's worth leasing if the return on an alternative investment is, say, 13%. In the problem on slides 9-18, if the real estate expenses on the building are higher, the ATIRR would be lower. In the problem on slides 9-18, the longer the holding period for the building, the lower the ATIRR. In the problem on slides 25-32, the longer the "new" holding period for the building (like in the chart on slide 23), the lower the ATIRR. Own-vs-lease decision (3 of 13) EXAMPLES Firm XYZ wants to open an office in a new area Annual business sales revenue: $800,000 Annual business expenses: $430,000 (50% of sales + $30K overhead) If LEASE for 15 years Annual lease payment: $100,000 If OWN (=BUY) for 15 years Property price today: $1,000,000 Building (85%): $850,000 Land (15%): $150,000 Building depreciable life: 30 years Property price in 15 years: $2,000,000 Interest-only loan for $760,000 (LTV=76%) Annual interest 10%, annual payments Annual real estate expenses: $50,000 (=50% of lease payment) Tax rate: 30% (annual income, capital gain, & depreciation recapture) p. 9 Own-vs-lease decision (4 of 13) To make financing & leasing more comparable, loan amount is purposefully picked so that it exactly equals the PV of lease payments at 10% for 15 years $760,000 PMT -100,000 N 15 I/Y CPT PV 10 PV = $760,608 p. 10 Own-vs-lease decision (5 of 13) What will be the general differences in the cash flows? If OWN (=BUY) If LEASE - Purchase price + Loan Yr 0 Yr 1-15 + Depreciation deduction + Interest deduction - Lease payments Yr 15 + Resale price - Loan balance - Tax on capital gain Tax on depreciation recapture p. 11 Own-vs-lease decision (6 of 13) If OWN (=BUY) Yr 0 Equity invested (1-76%) x 1,000,000 = 240,000 Yr 1-15 Sales revenue 800,000 - Business expenses - 430,000 -Real estate expenses on bldg - 50,000 - Interest - 10% x 760,000 loan = 76,000 - Depreciation allowance - 85% x 1,000,000 / 30 = 28,333 = Taxable income = 215,667 - Tax @ 30% - 30% x 215,667 = 64,700 + Add depreciation back + 28,333 = ATCF = 179,300 Yr 15 Resale price 2,000,000 - Loan balance - 760,000 loan - Tax on capital gain - 30% x (2m-1m) = 300,000 - Tax on depreciation recapture - 30% (15 x 28,333) = 127,500 = ATCF from sale = 812,500 p. 12 Own-vs-lease decision (7 of 13) If LEASE Yr 0 Yr 1-15 Sales revenue 800,000 - Business expenses - 430,000 - Real estate expenses on bldg - 50,000 - Lease payment - 100,000 = Taxable income = 220,000 - Tax @ 30% - 30% x 220,000 = 66,000 = ATCF = 154,000 Yr 15 p. 13 Own-vs-lease decision (8 of 13) If LEASE If OWN -240,000 800,000 - 430,000 50,000 800,000 - 430,000 - 50,000 - 100,000 Let's compare side by side: Yr 0 Equity invested Yr Sales revenue 1-15 - Business expenses - Real estate expenses on bldg - Lease payment - Interest - Depreciation allowance = Taxable income - Tax @ 30% + Add depreciation back = ATCF Yr 15 Resale price - Loan balance - Tax on capital gain - Tax on depreciation recapture = ATCF from sale = 220,000 66,000 76,000 28,333 = 215,667 64,700 + 28,333 = 179,300 2,000,000 - 760,000 - 300,000 - 127,500 = 812,500 = 154,000 p. 14 Own-vs-lease decision (9 of 13) Q: Worth it to open the new office & OWN the building? Year 0: Invest $240,000 of own money Year 1-15: Earn $179,300 after taxes Year 15: Sell the building & earn $812,500 after taxes A: Most likely YES! --- Q: Worth it to open the new office & LEASE the building? Year 0: Year 1-15: Earn $154,000 after taxes Year 15: A: Definitely YES! p. 15 Own-vs-lease decision (10 of 13) How should the Firm make the owning-vs-leasing decision? Step 1: For each year, calculate incremental After-Tax Cash Flows (ATCF) from owning-rather-than- leasing i.e., CF from owning - CF from leasing Step 2: Calculate the After-Tax IRR based on these ATCFs p. 16 Own-vs-lease decision (11 of 13) OWN LEASE OWN-LEASE Yr 0 Equity invested -240,000 -240,000 Yr Sales revenue 800,000 800,000 0 1-15 - Business expenses - 430,000-430,000 0 - Real estate expenses on bldg 50,000 50,000 0 - Lease payment - 100,000 100,000 - Interest 76,000 76,000 - Depreciation allowance 28,333 28,333 = Taxable income = 215,667 = 220,000 4,333 - Tax @ 30% 64,700 66,000 + 1,300 + Add depreciation back + 28,333 28,333 = ATCF = 179,300 = 154,000 + 25,300 Yr 15 Resale price 2,000,000 + 2,000,000 - Loan balance - 760,000 760,000 - Tax on capital gain - 300.000 300,000 - Tax on depreciation recapture 127 500 127 500 = A TCF from sale = 812,500 812,500 p. 17 Own-vs-lease decision (12 of 13) Calculate the After-Tax IRR based on the ATCFs from owning-rather-than-leasing: CFO: -240,000 C01-C14: 25,300 C15 25,300 + 812,500 = 837,800 CPT IRR After-Tax IRR from owning-rather-than-leasing = 15.40% Worth buying rather than leasing if the Firm believes that the 15.40% annual rate of return on $240,000 equity investment justifies any additional risks associated with owning rather than leasing the office building Also, if after-tax return earned elsewhere is lower than 15.40% p. 18 Own-vs-lease decision (13 of 13) This numerical problem in Excel: Microsoft Exce Worksheet What amount of lease payment makes the firm indifferent between buying & leasing? (1.e., calculate the "break-even" lease payment so that the IRR=0%) Use "goal seek" Set IRR cell to 60%" Get Lease payment = $9,429 What resale price in year 15 makes the firm indifferent between buying & leasing? (I.e., calculate the "break-even resale price so that the IRR=0%) Use "goal seek" Set IRR cell to 60%" Get Resale price = $639,004 p. 19 This problem is on Chapter 15. Help this turkey figure out which of the below are FALSE: Click on ALL that are FALSE! Do not try to click on all! Negative points will be given for any incorrectly clicked answers. In the problem on slides 9-18, if instead the loan was a 15-year fixed-rate amortizing loan, the ATIRR would be lower. In the problem on slides 9-18, if instead one wanted to calculate the ATIRR based on LEASE-rather-than-buy cash flows, then one would instead conclude that it's worth leasing if the return on an alternative investment is, say, 13%. In the problem on slides 9-18, if the real estate expenses on the building are higher, the ATIRR would be lower. In the problem on slides 9-18, the longer the holding period for the building, the lower the ATIRR. In the problem on slides 25-32, the longer the "new" holding period for the building (like in the chart on slide 23), the lower the ATIRR. Own-vs-lease decision (3 of 13) EXAMPLES Firm XYZ wants to open an office in a new area Annual business sales revenue: $800,000 Annual business expenses: $430,000 (50% of sales + $30K overhead) If LEASE for 15 years Annual lease payment: $100,000 If OWN (=BUY) for 15 years Property price today: $1,000,000 Building (85%): $850,000 Land (15%): $150,000 Building depreciable life: 30 years Property price in 15 years: $2,000,000 Interest-only loan for $760,000 (LTV=76%) Annual interest 10%, annual payments Annual real estate expenses: $50,000 (=50% of lease payment) Tax rate: 30% (annual income, capital gain, & depreciation recapture) p. 9 Own-vs-lease decision (4 of 13) To make financing & leasing more comparable, loan amount is purposefully picked so that it exactly equals the PV of lease payments at 10% for 15 years $760,000 PMT -100,000 N 15 I/Y CPT PV 10 PV = $760,608 p. 10 Own-vs-lease decision (5 of 13) What will be the general differences in the cash flows? If OWN (=BUY) If LEASE - Purchase price + Loan Yr 0 Yr 1-15 + Depreciation deduction + Interest deduction - Lease payments Yr 15 + Resale price - Loan balance - Tax on capital gain Tax on depreciation recapture p. 11 Own-vs-lease decision (6 of 13) If OWN (=BUY) Yr 0 Equity invested (1-76%) x 1,000,000 = 240,000 Yr 1-15 Sales revenue 800,000 - Business expenses - 430,000 -Real estate expenses on bldg - 50,000 - Interest - 10% x 760,000 loan = 76,000 - Depreciation allowance - 85% x 1,000,000 / 30 = 28,333 = Taxable income = 215,667 - Tax @ 30% - 30% x 215,667 = 64,700 + Add depreciation back + 28,333 = ATCF = 179,300 Yr 15 Resale price 2,000,000 - Loan balance - 760,000 loan - Tax on capital gain - 30% x (2m-1m) = 300,000 - Tax on depreciation recapture - 30% (15 x 28,333) = 127,500 = ATCF from sale = 812,500 p. 12 Own-vs-lease decision (7 of 13) If LEASE Yr 0 Yr 1-15 Sales revenue 800,000 - Business expenses - 430,000 - Real estate expenses on bldg - 50,000 - Lease payment - 100,000 = Taxable income = 220,000 - Tax @ 30% - 30% x 220,000 = 66,000 = ATCF = 154,000 Yr 15 p. 13 Own-vs-lease decision (8 of 13) If LEASE If OWN -240,000 800,000 - 430,000 50,000 800,000 - 430,000 - 50,000 - 100,000 Let's compare side by side: Yr 0 Equity invested Yr Sales revenue 1-15 - Business expenses - Real estate expenses on bldg - Lease payment - Interest - Depreciation allowance = Taxable income - Tax @ 30% + Add depreciation back = ATCF Yr 15 Resale price - Loan balance - Tax on capital gain - Tax on depreciation recapture = ATCF from sale = 220,000 66,000 76,000 28,333 = 215,667 64,700 + 28,333 = 179,300 2,000,000 - 760,000 - 300,000 - 127,500 = 812,500 = 154,000 p. 14 Own-vs-lease decision (9 of 13) Q: Worth it to open the new office & OWN the building? Year 0: Invest $240,000 of own money Year 1-15: Earn $179,300 after taxes Year 15: Sell the building & earn $812,500 after taxes A: Most likely YES! --- Q: Worth it to open the new office & LEASE the building? Year 0: Year 1-15: Earn $154,000 after taxes Year 15: A: Definitely YES! p. 15 Own-vs-lease decision (10 of 13) How should the Firm make the owning-vs-leasing decision? Step 1: For each year, calculate incremental After-Tax Cash Flows (ATCF) from owning-rather-than- leasing i.e., CF from owning - CF from leasing Step 2: Calculate the After-Tax IRR based on these ATCFs p. 16 Own-vs-lease decision (11 of 13) OWN LEASE OWN-LEASE Yr 0 Equity invested -240,000 -240,000 Yr Sales revenue 800,000 800,000 0 1-15 - Business expenses - 430,000-430,000 0 - Real estate expenses on bldg 50,000 50,000 0 - Lease payment - 100,000 100,000 - Interest 76,000 76,000 - Depreciation allowance 28,333 28,333 = Taxable income = 215,667 = 220,000 4,333 - Tax @ 30% 64,700 66,000 + 1,300 + Add depreciation back + 28,333 28,333 = ATCF = 179,300 = 154,000 + 25,300 Yr 15 Resale price 2,000,000 + 2,000,000 - Loan balance - 760,000 760,000 - Tax on capital gain - 300.000 300,000 - Tax on depreciation recapture 127 500 127 500 = A TCF from sale = 812,500 812,500 p. 17 Own-vs-lease decision (12 of 13) Calculate the After-Tax IRR based on the ATCFs from owning-rather-than-leasing: CFO: -240,000 C01-C14: 25,300 C15 25,300 + 812,500 = 837,800 CPT IRR After-Tax IRR from owning-rather-than-leasing = 15.40% Worth buying rather than leasing if the Firm believes that the 15.40% annual rate of return on $240,000 equity investment justifies any additional risks associated with owning rather than leasing the office building Also, if after-tax return earned elsewhere is lower than 15.40% p. 18 Own-vs-lease decision (13 of 13) This numerical problem in Excel: Microsoft Exce Worksheet What amount of lease payment makes the firm indifferent between buying & leasing? (1.e., calculate the "break-even" lease payment so that the IRR=0%) Use "goal seek" Set IRR cell to 60%" Get Lease payment = $9,429 What resale price in year 15 makes the firm indifferent between buying & leasing? (I.e., calculate the "break-even resale price so that the IRR=0%) Use "goal seek" Set IRR cell to 60%" Get Resale price = $639,004 p. 19
