Question

KP Inc. is negotiating a 10-year lease for three floors of space in a commercial office building. KP can’t use the space unless a security system is installed. The cost of the system is $50,000, and it will qualify as seven-year recovery property under MACRS. The building’s owner has offered KP a choice. The owner will pay for the installation of the security system and charge $79,000 annual rent. Alternatively, KP can pay for the installation of the security system, and the owner will charge only $72,000 annual rent. Assuming that KP has a 35 percent marginal tax rate, cannot make a Section 179 election to expense the $50,000 cost, and uses a 9 percent discount rate to compute NPV, which alternative should it choose?

Answer 1

The NPV of the cost of the first alternative is computed as follows.

Annual rent                                                                    $(79,000)

Tax savings of rent deduction at 35%                           27,650

After-tax cost of annual rent                                       $(51,350)

 

After-tax cost of year 0 rent                                    $(51,350)

NPV of after-tax cost of rent for years 1-9

($51,350 × 5.995 discount factor)                           (307,843)

NPV of annual rent cost                                             $(359,193)

 

 

The NPV of the second alternative is computed as follows.

Annual rent                                                                      $(72,000)

Tax savings of rent deduction at 35%                             25,200

After-tax cost of annual rent                                         $(46,800)

 

After-tax cost of year 0 rent                                          $(46,800)

NPV of after-tax cost of rent for years 1-9

($46,800 × 5.995 discount factor)                                 (280,566)

NPV of annual rent cost                                               $(327,366)

NPV of cost of leasehold improvement (see table)     (35,823)

Total NPV                                                                        $(363,189)

 

 

To minimize the cost of the lease in present value terms, KP should pay the higher rent and have the building’s owner pay for the $50,000 leasehold improvement.

 

Cost of Year Improvements 0 $(50,000) 1 2 3 4 5 6 7 NPV of leasehold improvement Recovery Tax Savings Net Cash Deduction at 35% $7,145 $2,501 12,245 4,286 8,745 3,061 6,245 2,186 1,563 1,561 1,563 781 4,465 4,460 4,465 2,230 Flow $(47,499) 4,286 3,061 2,186 1,563 1,561 1,563 781 Present Value at 9% $(47,499) 3,930 2,577 1,688 1,107 1,015 932 427 $(35.823)