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?