Question

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Claxton Drywall Comes to the Rescue

A law firm is expanding rapidly and must move to new office space. business is good, and the firm is encouraged to purchase an entire building for $10 million. the building offers first-class office space, is conveniently located near their most important corporate clients, and provides space for future expansion. The firm is considering how to pay for it.

Claxton Drywall, a consultant, encourages the firm not to buy the building but to sign a long-term lease for the building instead. "With lease financing, you'll save $10 million. You won't have to put up any equity investment", Drywall explains.

The senior law partner asks about the terms of the lease. "I've taken the liberty to check", Drywall says. "The lease will provide 100% financing. It will commit you to 20 fixed annual payments of $950,000, with the first payment due immediately."

"The initial payment of $950,000 sounds like a down payment to me", the senior partner observes sourly.

"Good point", Drywall ways amiably, "but you'll still save $9,050,000 up front. You can earn a handsome rate of return on that money. For example, I understand you are considering branch offices in London and Brussels. The $9 million would pay the costs of setting up the new offices, and the cash flows from the new offices should more than cover the lease payments. And there's no financial risk-the cash flows from the expansion will cover the lease payments with a safety cushion. There's no reason for you or your partners to worry or to demand a higher-than-normal rate of return".

Questions:

Suppose the present value of the building equals its purchase price of $10 million. Assume that the law firm can finance the offices in London and Brussels from operating cash flow, with cash left over for the lease payments. The firm will not default on the lease payments. For simplicity you can ignore taxes.

1. If the law firm takes the lease, it will invest $950,000 an in effect borrow $9,050,000, repaid by 19 installments of $950,000. What is the interest rate of return on this disguised loan?

2. The law firm could finance 80% of the purchase price with a conventional mortgage at a 7% interest rate. Is the conventional mortgage better than the lease?

3. Construct a simple numerical example to convince Drywall that the lease would expose the law firm to financial risk. Hint : What is the rate of return on the firm's equity investment in the office building if a recession arrives and the market value of the (leased) office building falls to $9 million after one year? What is the rate of return with the conventional mortgage financing? With all-equity financing?

4. Do the investments in London and Brussels have anything to do with the decision to finance the office building? Explain briefly.

Answer 1

1. Assuming this as an annuity-due lease, where the first payment is made immediately,

equating the PVs, using the PV of annuity-due formula for 20 annual payments of 950000

10000000=(950000*(1-(1+r)^-20)/r)*(1+r)

Solving for r , we get,

the interest rate on the lease= 8.11%

Total cash outflow under lease will be 950000*20= 19000000

2. As 80% *10000000 =8000000 is financed,

monthly payment on the mortgage will be

taking monthly rate=7%/12= 0.5833%,

8000000=Pmt*(1-1.005833^-240)/0.005833

Monthly payment = 62022

so, total Yearly payment= 62022*12=744264

Total cash outflow under mortgage will be

(62022*12*20)+2000000=

=16885280

So, the conventional mortgage is cheaper than leasing.

3. Leasing will expose the firm to financial risk,

ie. When the market value of the leased building falls from 10 million to 9 million, the law firm stands to lose by way of higher annual lease payments, calculated based on the original price--which affects the net income & consequent return to shareholders' equity.

Whereas,

under the conventional mortgage, the firm can deduct periodic mortgage payments towards interest, and also claim depreciation for the buildings purchased.

As interest payments are less under mortgage, it creates more return to equity.