Question

Close Knit has decided to locate a new factory in Worcester, MA. The company will either buy or lease a site depending on which is more advantageous. Calculate the present value of each of the following 3 scenarios and make a recommendation to Close Knit assuming an interest rate of 12%.

a. Building A – Purchase for a cash price of $600,000, useful life is 25 years
b. Building B – Lease for 25 years with annual lease payments of $69,000 being made at the beginning of each year
c. Building C – Purchase for $650,000 cash. This building is larger than needed; however, the excess space can be sublet for 25 years at a net annual rental of $7,000. Rental payments will be received at the end of each year, and Close Knit has no aversion to being a landlord.

Answer 1

Close Knit

1. Present values of each of the following 3 scenarios:

Scenario A Scenario B Scenario C

Present value $600,000 $606,117.79 $595,098

2. Recommendation: Scenario C is recommended because its cost is the lowest.

Step-by-step explanation:

a) Data and Calculations:

Interest rate = 12%

Number of periods for cash flows = 25 years

Frequency of cash flows = annual

Scenario A, Present value of investment = $600,000

Scenario B, Present value of investment = $606,117.79

Scenario C, Present value of investment = $595,098 ($650,000 - $54,901.97) (cost savings)

Online Finance Calculations:

Scenario B:

N (# of periods) = 25

I/Y (Interest per year) = 12

FV (Future Value) = 0

P/Y (# of periods per year) = 1

C/Y (# of times interest compound per year) = 1

PMT made at the of each period

Results

PV of cash inflows = $606,117.79

Sum of all periodic payments = $-1,725,000.00

Total Interest = $1,118,882.21

Scenario C: for Cash inflows of $7,000 annually

N (# of periods) = 25 years

I/Y (Interest per year) = 12%

PMT (Periodic Payment) = $-7000

FV (Future Value) = 0

Results

PV = $54,901.97

Sum of all periodic payments = $-175,000.00

Total Interest = $120,098.03