Question

Jensen Company owns a building in a suburban industrial park. It purchased the building four years ago for $3 million. It is now deciding whether to lease the building or to use it as a distribution center. It could be rented immediately. Given today’s market conditions, rental income of $120,000 per year would be expected. To convert the building to make it useful as a distribution center would require an immediate expenditure of $400,000. Having the distribution center at this location would provide Jensen with $140,000 per year in cost savings, at today’s prices. The cash flows associated with this decision are not very risky, so a real discount rate of just 3% per year is required. For simplicity, assume that: (i) there are no taxes, (ii) the building could be rented or used as a distribution center forever, (iii) ongoing cash flows, including rents and distribution cost savings, would increase with the overall inflation rate, and (iv) all cash flows except the initial $400,000 would occur at year end. (the last assumption implies that one year of inflation would affect the first lease payment and distribution cost saving)

(a) The inflation rate is forecast to be 4% per year. What nominal discount rate is appropriate for this project?

(b) Provide a NPV analysis and a recommendation of how the building should be used.

(c) Is the outcome of your NPV analysis sensitive to changes in the assumed inflation rate? (An intuitive answer without numbers is OK).

(d) Based on the information provided, is it possible to estimate the current market value of the building? If so, provide an estimate.

Answer 1

Real Rate of Interest = 3%
Inflation Rate t= 4%
(a)
Nominal discount rate = (1+ Real Rate of interest) * (1+ inflation Rate)
Nominal discount rate = (1+3%)*(1+4%)
Nominal discount rate = 7.12%
(b)
Cost incur to purchase the building 4 year ago is sunk cost and will not consider for decision making
Option A: to rent out the building
Discount Rate is 7.12%
Rental Income = $120,000 per year ( Rec. at the end of year after adjusted for inflation)
Present value of future discounted cash flow is =	($1,20,000)(1+4%)
(7.12%-4%)
=	4,000,000
Option B: Distribution centre
Savings expected from distribution centre is $ 140,000 ( Rec. at the end of year after adjusted for inflation)
Cost incure today is $400,000
Present value of cash inflows =	$140,000 (1+4%)
(7.12%-4%)
=	4,666,667
Net cash inflow (NPV) = $4,666,667-$400,000 = $4,266,667
Since NPV of Building to be as distribution centre is more, it should be used as distribution centre.
( c )
No, outcome of NPV is not sentivity with inflation. Since, if inflation not there then, discount rate will be real rate of interest only and answer will be same.
(d)
Current market of the building is the present value of all the future cash inflows which can be generated through it.
Thus value of building is $ 4,266,667