Question

Exercise 6-12 The Flint Inc., a manufacturer of low-sugar, low-sodium, low-cholesterol TV dinners, would like to increase its market share in the Sunbelt. In order to do so, Flint has decided to locate a new factory in the Panama City area. Flint will either buy or lease a site depending upon which is more advantageous. The site location committee has narrowed down the available sites to the following three very similar buildings that will meet their needs.

Building A: Purchase for a cash price of $618,900, useful life 27 years.

Building B: Lease for 27 years with annual lease payments of $71,820 being made at the beginning of the year.

Building C: Purchase for $652,700 cash. This building is larger than needed; however, the excess space can be sublet for 27 years at a net annual rental of $6,430. Rental payments will be received at the end of each year. The Flint Inc. has no aversion to being a landlord.

In which building would you recommend that The Flint Inc. locate, assuming a 12% cost of funds? (Round factor values to 5 decimal places, e.g. 1.25124 and final answer to 0 decimal places, e.g. 458,581.)

Net Present Value

Building A: $

Building B: $

Building C: $

The Flint Inc. should locate itself in:

Answer 1

Net present value is the difference between the present value of inflows and outflows in cash. Net present value technique is used in capital budgeting to evaluate various alternatives. In the present case, the building is to be evaluated on the basis of cost. Hence, the NPV of the building which is least shall be chosen.

Building A

Since it is purchased in cash, the present value would be $ 618,900

Building B

This is case of annuity due as lease payments are made at the beginning of the year. So, the interest factor or annuity due should be taken.

Present value     =lease payment * (PV of annuity due for 27 periods at 12%)

                                = 71,820 * 8.89566

                                = $ 638,886

Building C

The present value of lease rentals have to be deducted from the cash price i.e. present value of purchase price.

Lease rentals are paid at the beginning of each period. This is a case of ordinary annuity.

The present value of lease rentals             = Lease rental * (PV of ordinary annuity for 27 years at 12%)

                                                                                = 6430 * 7.94255

                                                                                = $ 51071 rounded off

Net present value            = cash purchase price – present value of rentals

                                                = 652,700 – 51,071

                                                = $ 601,629

The Flint Inc should locate itself in Building C as its present value is the lowest.

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