Question

Topic:

It is important to consider the time value of money along with financial risk when making financial decisions.   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 on 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 an office or lease? Choose the best answer and justify your answer by calculating the time value of money. What other factors should you use besides the time value of money? Why?

Answer 1

Given data: Cost of New Office : $ 500000; Down Payment : $ 100000

Lease rental cost : $ 3500 permonth = $ 42000 per annum and with a 3 - year contractual obligation;

Market Rate of Return = 11.3%

Other assumpions:

Have considered two commercial loan options with the assumption of same rate of interest of 11.3% and for different tenures (5 years and 3 years);

Based on the same, the workings are as below:

Cost of Condo		5,00,000
Down Payment		1,00,000
Amount Need to Borrow		4,00,000
Loan	Rate (I/Y)	Period (N)	Amount (PV)	Nature	PMT / Annual	Total Paid (FV)
Option A	11.30%	3	4,00,000	Fixed	1,64,540	4,93,620
Option B	11.30%	5	4,00,000	Fixed	1,09,046	5,45,230
				Loan	PMT / Monthly
				Option A	13,712
				Option B	9,087

Based on the above assumptions, the annual mortgage payments shall be much higher than that of the lease rental payments;

Lease / Annum	Tenure	R%	FV
42,000	3	11.30%	1,40,774

What should you do: buy an office or lease? Choose the best answer and justify your answer by calculating the time value of money.

Answer to this question could be multifolded, as it depends on the actual cashflow and the financial capacity of the firm. If there borrowing power, it is appropriate to own an asset by taking a mortgage; Although, the mortgage payments are higher as compared to the lease rental payments, this has couple of benefits

- the office shall be owned by the company

- the annual depreciation amount can be offered for tax deductions and this shall significantly decrease the overall tax costs

- at the terminal year, the office can be either sold for some salvage value or can be leased out, which shall have certain econimic benefits,

However, the time value of the money need to be assessed while evaluating these options; From the given options of Option Loan A and Option Loan B, it is evident from the Future Values of the amounts that the higher the tenure, the higher the overall amount being shelled out, on the same amount of loan taken today. This justifies the concept of time value that the more prolonged, the more the value (positive interms of revenue, loss interms of costs)

The other option is the lease rental - In this option, the benefit is that the lower annual payments and tax benefits to such extent; Apart from this, no other benefit as stated above.

If the new office requirement is only for 3 years, then it is appropriate to go for leasing option with no other complexities; If the office requirement is for long term, then it is appropriate to choose the purchase option.

What other factors should you use besides the time value of money? Why?

These types of decisions need many other factors under consideration; Few of them are the Tax base of the firm, financial capability of the firm, expected tenure of the requirement of office, cost of asset vs cost of leasing etc.

Tax base is essential to understand the actual benefits the firm can achieve - thru net cash flows; Financial capabiliity is important to assess whether the liquidity of the company can support the higher mortgage payments or not; Expected Tenure is required to understand on the life of the requirement - short term or long term, as incase of long term, capital expense is preferred.