Question

Alternative 1

Slowtwitch has identified a parcel of land that is for sale. The listing price is $400,000, but Slowtwitch's realtor is confident the property can be acquired for $330,000. An architect has provided Slowtwitch with plans to build a retail store on this site at a cost of $1,000,000. An additional $320,000 would be required to finish out the building with all of the equipment, furniture, and fixtures necessary to meet Slowtwitch's demanding standards. Slowtwitch's banker has agreed to finance this deal, with a loan package that would require a $500,000 down payment plus five annual payments of principal and interest equaling $350,000 (made at the end of year). Slowtwitch expects to use the retail store for 12 years, and then it is anticipated that the facility can be sold for $480,000. Based on data from Slowtwithc's other stores of similar size, you are able to determine the following annual operating expenses: insurance = $28,000 (to be paid at the beginning of each year), property taxes = $40,000 (to be paid at the end of each year), regular maintenance = $16,000 (which occurs at the end of years 6 through 12). Determine the following:

	Total Cash Flows	Discounted Cash Flows (ie: Present Value)
Down Payment	$<500,000>
Installment payments on bank note	<1,750,000>
Insurance	<336,000>
Property Taxes	<480,000>
Regular Maintenance	<112,000>
Sale of Building	480,000

Net Cash Flows:

Alternative 2

Slowtwitch's banker is 20 pounds overweight, is a 2 pack a day smoker, and would rather eat sawdust than Powerbars. He cannot compete athletically on the same level as the Slowtwitch executives. However, he does like to think of himself as somewhat of a financial whiz-bang, and he thinks he can impress these guys by saving them money. Thus, he proposes to sell his condo in Vail and use the proceeds to purchase the land, build the retail store, and outfit it with equipment, furniture, and fixtures; if, Slowtwitch will lease the site from him under a 12-year, non-cancellable lease. The banker has crunched the numbers and has come up with the following lease terms: $230,000 annual lease payment (the first payment payable on the day the store opens, and the remaining eleven payments at the beginning of each succeeding year). In addition, the banker will require a compensating balance of $100,000 to remain on deposit in a non-interest bearing account at his bank. This deposit will be returned to Slowtwitch at the end of the twelfth year, assuming no major damage to the retail store structure has occurred. At that time, Slowtwitch will vacate the building or renegotiate the contract with the banker.

	Total Amount	Discounted Amount (ie: Present Value)
Lease Payments	$<2,760,000>
Opportunity Cost (interest lost on security deposit
NET CASH FLOWS

Which of the two approaches should Slowtwitch Inc. follow, assuming Slowtwitch's current cost of funds is 8%? (Support your answer with all necessary calculation. You must show your work to receive credit for this assignment.)

Answer 1

Alternative 1.  

Following is the discounted Cash flow :-

Particulars	Total Cash flows	discounted Cash flows (i.e. present value )
Down payment	(500000)	(500000)
Installment payment on bank note	(1750000)	($1397450)
Insurance	(336000)	($227890)
Property taxes	(480000)	($301445)
Regular maintenance	(112000)	(56695)
Sale of building	480000	$190610
Net cash flows	($2698000)	($2292870)

Note

1 . Since down payment is to be made upfront . Therefore , present value of down payment will be actual amount paid.

2. Present value of annuity of 350000 for 5 years = 350000 x pvaf (8%,5)

= 350000 x 3.9927 = $1397450

3 . Present value of the annuity of insurance payment amounting to 28000 per year in the beginning of the year for the total of 12 years = 28000 + 28000 x pvaf (8%,11)

= 28000+ 28000x7.1390

= 28000+199890

=$227890.

4 . Present value of the annuity of property tax to be paid at the end of the year for 12 years = 40000 x pvaf (8%,12)

= 40000 x 7.5361

= $301445.

5. Regular maintenance is from 6 to 12 years only

Thus , present value = 16000 x [{pvaf(8%12)}-{pvaf(8%,5)}]

= 16000 x (7.5361-3.9927)

= 16000 x 3.5434

=$56695

6 . Present value of sale of building = 480000 x pvif (8%,12)

= 480000 x 0.3971

$190610

Alternative 2 . Following are the discounted cash flows and net cash flows

Particulars	Total amount	discounted amount i.e. present value
Lease payments	($2760000)	($1871970)
Opportunity cost (interest lost in security deposit)	($96000 )(note 2 below)	(38122)
Net cash flows	($2856000)	($1910092)

Since total present value of net cash flow is less in case of alternative 2, thus, alternative 2 should be selected.

Note

1. Present value of series of lease payment payable for 12 years at the beginning of each year

= 230000+230000xpvaf(8%,11)

= 230000 + 230000 x 7.1390

230000+1641970

= $1871970

2 . Interest lost on deposit = 100000 x 8% x 12 = $96000.

Present value = 96000xpvif (8%,12)

= 96000 x 0.3971 = $38122