The Lease or Buy Decision

Top-Quality 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, Sam Watkins, the companys vice president in charge of sales, stated, I know most of our competitors are starting to lease facilities rather than buy, but I just cant 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, thats 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, thats a net cost to us of only $710,000. What would it cost to lease the property? Annual depreciation on the property will be (assuming straight-line depreciation) $19,444 per year. This is a noncash expense, but it does reduce income taxes in the amount of the depreciation charge multiplied by the marginal tax rate, assumed to be 25%.

I understand that Beneficial 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 Lisa Coleman, the companys executive vice president.

Thats just my point, said Sam. At $120,000 a year, it would cost us a cool $2,160,000 over the 18 years. Thats 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!

Youre overlooking a few things, replied Lisa. For one thing, the treasurers 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 havent figured in. The loan payment schedule is shown below, with Top-Quality paying an annual 15% interest rate.

Year	Payment	Interest	Principal	Balance
				$ 500,000
1	$175,000	$75,000	$100,000	400,000
2	175,000	60,000	115,000	285,000
3	175,000	42,750	132,250	152,750
4	175,000	22,913	152,088	663

But that little bit of interest is nothing compared to over 2 million bucks for leasing, said Sam. Also, if we lease I understand we would have to put up an $8,000 security deposit that we wouldnt 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, Ill admit that I dont have all the figures sorted out yet, replied Lisa. 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, Beneficial will handle its own insurance costs and of course, the owner will have to pay the property taxes. Ill 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. Lets see, a development said the first lease payment would be due now and the remaining ones due in years 1-17. Development also said that this store should generate a net cash inflow thats well above the average for our stores.

Required:

Using the net present value approach, determine whether Top-Quality Stores, Inc., should lease or buy the new facility. Factor income taxes into your analysis (lease payments, interest, depreciation, property taxes, insurance, and repairs are tax-deductible expenses). Assume Top-Quality Stores, Inc., is in a 25% marginal tax bracket. Please make your analysis complete, neat, and easy to follow.