A company is planning to move to a larger office and is trying to decide if the

Question

A company is planning to move to a larger office and is trying to decide if the new office should be owned or leased. The incremental sales from opening the new office are $1, 200,000. The cost of goods sold is 40%. The operating expenses for the business are an additional $150,000 and the operating expenses for the building, whether you lease or own. are $100,000. You can either purchase the property for $1,600,000, with a 75% loan at interest only, for 15 years. or you can lease the property for $200,000 per year for a 15-year period. The properly will be worth $2,000,000 when the fifteen year period is exhausted. Assume the capital gains tax on sale is $200,000. What is the differential return from owning rather than leasing Bonus question: what impact if any is there on the return if the loan is amortizing (think qualitatively)

Explanation / Answer

For Part A:

The ineterst payment is calculated as follows : The total loan amount is 75% of 1,600,000 = 1,200,000. The interest of 8% on 1,200,000 = 96,000 which is the interest expense

The deprciation on land is taken as zero (0) as land is assumed to have unlimited life

The table is as shown below:

For Part B:

Now for the sale of the land after 15 years, the mortagage would be fully paid at the end of 15 years and the balance of the mortgage would be zero. The results are tabulated as follow:

Hence is additional cash flow from buying and hence owning is preferred over leasing

The return on owning (as a percentage of sales) would be 243100/1200000 = 20.26%

The return on leasing (as a percentage of sales) would be 175500/1200000 = 14.63%

Hence the incremental differntial return on owning rather than purchasing is 20.26 - 14.63 = 5.63%

Own Lease Sales 1200000 1200000 COGS 480000 480000 Operating expenses: Business 150000 150000 Real estate 100000 100000 Lease payments 200000 Interest Expense 96000 Deprecaition 0 0 taxable Income 374000 270000 Tax at 35% 130900 94500 After tax Cash flow 243100 175500

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