Question

Imagine your company must decide whether to buy or lease office space. Determine the best course of action for your company using the information below:

Assume the stock market returns 11.3% per year on average.

Your company has $100,000 to spend for the down payment on the purchase of a new office.

A new office will cost $500,000

To rent a new office it will cost your company $3,500 per month and you will need to sign a 3 year lease.

Find any other information that is necessary to perform the calculation, such as the current market rate for a commercial loan.

What should you do: Buy or lease? Explain which option you believe is best, and justify your answer by calculating the time value of money. Describe other factors you should consider besides the time value of money, and explain why they are important.

Answer 1

New Office:

Cost - $ 500,000

Down payment - $ 100,000

Lease / Rent:

$3,500 per Month for 3 Years.

Other Information that is necessary to perform the calculation:

Purchase New Office:

If we want to purchase new office, we require the following additional information.

1. If we are going to borrow a loan for $ 500,000, then the Interest Rate at which loan can be availed.
2. If we are going to issue Stock for $ 500,000, then we need to ensure that we atleast reach the market expectation by giving a return of 11.3% to stock holders.
3. Useful life of the Asset, Depreciation Method, Salvage Value.
4. Tax Rate Applicable to the entity.

Lease/Rent Option:

If we want to lease the building for a specified period as said in question like 3 years, we need the following information:

1. Cost of Capital to the Company

For Now, if we assume that the Company’s Cost of Capital is 10% p.a and the company can borrow loan @ 10%. Loan is to be repaid at the end of each year within 3 years. Useful Life of Asset is 3 Years. SLM Method is followed. Tax Rate is 30%. Salvage Value is 200,000. Best Option can be arrived as follows:

When Asset is Purchased:

Depreciation: 500000-200000 / 3 = 100,000

Tax Savings on Depreciation = 100,000 * 30% = 30,000

Interest:

EMI = 500,000 / 2.4868 = 201,061.60

Year	Opening Principal	Interest	Repayment of Principal	Closing Principal	Tax Savings on Interest
1	500,000.00	50,000.00	151,061.60	348,938.40	15,000.00
2	348,938.40	34,893.84	166,167.76	182,770.64	10,468.15
3	182,770.64	18,277.06	182,770.64	-	5,483.12

Total Cash Outflow:

Year	Repayment of Loan	Tax Savings on Depreciation	Tax Savings on Interest	Total Outflow	PVF @ 10%	Discounted Cash Flow
1	201,061.60	30,000	15,000.00	156,061.60	0.9091	141,875.60
2	201,061.60	30,000	10,468.15	160,593.45	0.8264	132,714.42
3	201,061.60	30,000	5,483.12	165,578.48	0.7513	124,399.11

If we go for Loan Option we have a Net Outflow = 398,989.13 – 150,260 ^(*) = 248,729.13

• Note – Salvage Value = 200,000 * 0.7513 = 150,260.

Lease Option:

Lease amount per month = $ 3,500

Lease amount per Annum = $ 42,000

Lease Amount for 3 Years = $ 42,000* 2.4868 (PVF 10%,3Yrs) = $ 104,445.60

Conclusion : Lease Option is more beneficial in terms of Cash Outflow.

Other Factors to be considered:

1. Cost of Capital to the Company.

2. Period for which the Asset will be used by the company.

3. Tax Rate applicable to the Entity.