Question

P6-10 (Analysis of Lease vs. Purchase) Dunn Inc. owns and operates a number of hardware stores in the New England region. Recently, the company has decided to locate another store in a rapidly growing area of Maryland. The company is trying to decide whether to purchase or lease the building and related facilities.Purchase: The company can purchase the site, construct the building, and purchase all store fi xtures.The cost would be $1,850,000. An immediate down payment of $400,000 is required, and the remaining $1,450,000 would be paid off over 5 years at $350,000 per year (including interest payments made at end of year). The property is expected to have a useful life of 12 years, and then it will be sold for $500,000. As the owner of the property, the company will have the following out-of-pocket expenses each period.Property taxes (to be paid at the end of each year) $40,000Insurance (to be paid at the beginning of each year) 27,000Other (primarily maintenance which occurs at the end of each year) 16,000 $83,000Lease: First National Bank has agreed to purchase the site, construct the building, and install the ap-propriate fi xtures for Dunn Inc. if Dunn will lease the completed facility for 12 years. The annual costs forthe lease would be $270,000. Dunn would have no responsibility related to the facility over the 12 years. The terms of the lease are that Dunn would be required to make 12 annual payments (the fi rst paymentto be made at the time the store opens and then each following year). In addition, a deposit of $100,000 is required when the store is opened. This deposit will be returned at the end of the twelfth year, assuming no unusual damage to the building structure or fi xturesInstructionsWhich of the two approaches should Dunn Inc. follow? (Currently, the cost of funds for Dunn Inc. is 10%.)

Answer 1

	Purchase
		a	b	c	d	e=a+b+c+d	f		g=e*f
	Year	Down Payment, Installment & Sale	Property tax year end	Insurance at year beginning	Other maintainence year end	Total cash outflow	Present value factor@10%		Present value of cashoutflow
	0	400,000		27000		427,000	1	1	427,000
	1	350,000	40000	27000	16000	433,000	0.90909091	=(1/1.1)^1	393,636
	2	350,000	40000	27000	16000	433,000	0.82644628	=(1/1.1)^2	357,851
	3	350,000	40000	27000	16000	433,000	0.7513148	=(1/1.1)^3	325,319
	4	350,000	40000	27000	16000	433,000	0.68301346	=(1/1.1)^4	295,745
	5	350,000	40000	27000	16000	433,000	0.62092132	=(1/1.1)^5	268,859
	6		40000	27000	16000	83,000	0.56447393	=(1/1.1)^6	46,851
	7		40000	27000	16000	83,000	0.51315812	=(1/1.1)^7	42,592
	8		40000	27000	16000	83,000	0.46650738	=(1/1.1)^8	38,720
	9		40000	27000	16000	83,000	0.42409762	=(1/1.1)^9	35,200
	10		40000	27000	16000	83,000	0.38554329	=(1/1.1)^10	32,000
	11		40000	27000	16000	83,000	0.3504939	=(1/1.1)^11	29,091
	12	-500000	40000		16000	(444,000)	0.31863082	=(1/1.1)^12	(141,472)
							Present cost of purchasing		2,151,393
	Leasing
		a	b	c=a+b	d		e=c*d
	Year	Annual lease at year beginning	Deposit	Total cash outflow	Present value factor@10%		Present value of cashoutflow
	0	270,000	100000	370,000	1	1	370,000
	1	270,000		270,000	0.90909091	=(1/1.1)^1	245,455
	2	270,000		270,000	0.82644628	=(1/1.1)^2	223,140
	3	270,000		270,000	0.7513148	=(1/1.1)^3	202,855
	4	270,000		270,000	0.68301346	=(1/1.1)^4	184,414
	5	270,000		270,000	0.62092132	=(1/1.1)^5	167,649
	6	270,000		270,000	0.56447393	=(1/1.1)^6	152,408
	7	270,000		270,000	0.51315812	=(1/1.1)^7	138,553
	8	270,000		270,000	0.46650738	=(1/1.1)^8	125,957
	9	270,000		270,000	0.42409762	=(1/1.1)^9	114,506
	10	270,000		270,000	0.38554329	=(1/1.1)^10	104,097
	11	270,000		270,000	0.3504939	=(1/1.1)^11	94,633
	12		-100000	(100,000)	0.31863082	=(1/1.1)^12	(31,863)
					Present cost of leasing		2,091,803
	Since the cost of leasing is less than cost of purchasing. Lease should be opted.