Question

The ABC Corporation is considering opening an office in a new market area that

would allow it to increase its annual sales by $2.6 million. The cost of goods sold is
estimated to be 40 percent of sales, and corporate overhead would increase by
$306,500, not including the cost of either acquiring or leasing office space. The
corporation will have to invest $2.6 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 $5.8 million, of which $900,000 of the purchase price would represent land
value, and $4.9 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
$645,000 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 $6.3 million at the
end of the 15 years. the property is purchased, it would be financed with an interest-
only mortgage for $3,280,000 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?

Answer 1

A:

The return from opening the office building under the assumption that it is leased would be the difference between the net income generated by the increase in sales and the expenses associated with opening the new office, including the cost of leasing the office space.

To calculate the net income generated by the increase in sales, we first need to calculate the total cost of goods sold. Since the cost of goods sold is estimated to be 40 percent of sales, the cost of goods sold for the new office would be 40 percent x $2.6 million = $<<40*.01*2.6=1.04>>1.04 million.

Subtracting the cost of goods sold from the increase in sales, we find that the net income generated by the increase in sales would be $2.6 million - $1.04 million = $<<2.6-1.04=1.56>>1.56 million.

Next, we need to calculate the expenses associated with opening the new office, including the cost of leasing the office space. Since the corporate overhead would increase by $306,500, the total up-front costs associated with opening the new office would be $306,500 + $2.6 million = $<<306.5+2.6=2.906>>2.906 million.

To calculate the cost of leasing the office space, we need to multiply the annual lease payment by the number of years in the lease term. Since the annual lease payment is $645,000 and the lease term is 15 years, the total cost of leasing the office space would be $645,000 x 15 years = $<<645000*15=9675000>>9.675 million.

Subtracting the total up-front costs and the cost of leasing the office space from the net income generated by the increase in sales, we find that the return from opening the office building under the assumption that it is leased would be $1.56 million - $2.906 million - $9.675 million = $<<1.56-2.906-9.675=-9.020>>-9.020 million. This means that the corporation would incur a loss of $9.020 million by opening the new office and leasing the office space.

B:

C:

To calculate the return on the incremental cash flow from owning versus leasing, we need to subtract the cash flow from leasing the office space from the cash flow from owning the office space.

First, let's calculate the cash flow from leasing the office space. We already know that the total cost of leasing the office space would be $9.675 million. To calculate the cash flow from leasing the office space, we need to subtract the real estate operating expenses from the total cost of leasing the office space. Since the real estate operating expenses are estimated to be 50 percent of the lease payments, the real estate operating expenses would be 50 percent x $645,000 = $<<50*.01645=322500>>322,500 per year. Since the lease term is 15 years, the total real estate operating expenses would be $322,500 x 15 years = $<<322.515=4837.5>>4,837,500. Subtracting the real estate operating expenses from the total cost of leasing the office space, we find that the cash flow from leasing the office space would be $9.675 million - $4.837.5 million = $<<9.675-4.837.5=4.837.5>>4,837,500.

Next, let's calculate the cash flow from owning the office space. We already know that the total up-front costs associated with opening the new office would be $2.906 million. To calculate the cash flow from owning the office space, we need to subtract the total annual operating expenses from the net income generated by the increase in sales. Since the net income generated by the increase in sales is $1.56 million and the total annual operating expenses are $217,774.36, the cash flow from owning the office space would be $1.56 million - $217,774.36 = $<<1.56-217774.36=1.34222564>>1,342,225.64.

Finally, to calculate the return on the incremental cash flow from owning versus leasing, we need to subtract the cash flow from leasing the office space from the cash flow from owning the office space. Therefore, the return on the incremental cash flow from owning versus leasing would be $1,342,225.64 - $4,837,500 = $<<1.34222564-4.837.5=-3.495.5>>-3,495,500. This means that the corporation would incur a loss of $3.495.5 million by choosing to own the office space instead of leasing it.