Question

In: Accounting

Facts: Opportunity Landscaping Inc. (Opportunity) appreciated your assistance in preparing their 2018 Federal income tax return....

Facts: Opportunity Landscaping Inc. (Opportunity) appreciated your assistance in preparing their 2018 Federal income tax return. As a result, they have come to you for advice on acquiring new facilities for their manufacturing operations. They plan to take access to their new facilities on January 2, 2020.

The corporation has the opportunity to purchase an appropriate facility in suburban Chicago for $90,000,000 ($87,000,000 for the factory building; $3,000,000 for the land). If they purchase the facility, they would finance the acquisition via a 15-year mortgage at 3.5% interest with a $18,000,000 down payment (due at closing on January 2, 2020). The mortgage would be payable annually in arrears (i.e., the first mortgage payment would be due January 2, 2021). Real property taxes on the facility in 2020 would be $1,000,000 (the property taxes are also due annually in arrears with 2020 taxes due on January 2, 2021). Further, Opportunity estimates that property taxes will increase annually at a rate of 3% in years subsequent to 2020.

As an alternative, a local real estate investor has offered to purchase the facility and lease it to the corporation. The investor would require Opportunity to sign a 7-year non-cancelable lease. The first lease payment of $3,700,000 would be due on January 2, 2020. Lease payments will increase by 4% each year during the term of the lease with the final lease payment due on January 2, 2026. In addition, the lease would require a refundable deposit of $1,850,000 (payment due on January 2, 2020) against significant damages to the facility; this deposit will be refunded to the corporation on January 2, 2027 (when the occupancy ends and assuming that there are no significant damages).

Opportunity must decide whether to lease or buy the facility. In order to make a proper decision, the corporation will assume that it could sell the facility (building and land) on January 2, 2027 for $100,000,000. Under this scenario, they would make their final mortgage and property tax payments on January 2, 2027 and then sell the facility.

Opportunity’s Federal corporate tax rate is 21% and it uses a 7% discount rate to compute the present value of its future cash flows. For purposes of this analysis, assume that all cash flows occur at the beginning of the respective year.

Required:

1. Based on the above facts, which option (lease or buy) minimizes Opportunity’s after-tax cost of obtaining the facility?

2. The local real estate investor has provided an option for Opportunity to consider. Under this option, a payment of $12,000,000 is due on January 2, 2020. If this payment is made, no deposit is required and the payment is deemed to cover the first three years of the lease. On January 2, 2023, lease payments resume with a $4,000,000 lease payment due (and a 4% increase in the lease payment each year for the remainder of the lease term). Is this an alternative that Opportunity should consider? Read and apply the materials in text Section 6-2d as part of your analysis.

3. Opportunity’s CFO is not certain that the current 21% Federal tax rate will be maintained over the next seven years. She feels that an increase in the Federal rate to around 30% is likely at some point in the near term. As a result, she would like to know how your analysis would be affected if the Federal income tax rate increased to 30% on January 1, 2025.

I have calculated and found that the NPV for the lease option is ($19,516,098). I have also used the PMT function on excel and found that the annual mortgage payments are $6,251,405 (15 years; $72 million; 3.5% interest rate). I need help computing the NPV for the buy option in order to decide which option is best.

Expert Solution

Calculation of Present Value of Cash Outflows in Buying Option

Year	Annual mortgage	Property Tax	Interest	Tax Shield on Int	Cash Outflow	DF @ 7%	Present Value
2020	6251405	1000000	2520000	529200	9242205	0.935	8641462
2021	6251405	1030000	2389401	501774	9169032	0.874	8013734
2022	6251405	1060900	2254231	473389	9093147	0.817	7429101
2023	6251405	1092727	2114330	444009	9014453	0.764	6887042
2024	6251405	1125509	1969532	413602	8932844	0.714	6378050
2025	6251405	1159274	1819666	382130	8848215	0.667	5901759
2026	6251405	1194052	1664556	349557	8760456	0.623	5457764
2027	6251405	1229874	1504016	315843	8669452	0.582	5045621
2028	6251405	1266770	1337857	280950	8575082	0.544	4664845
2029	6251405	1304773	1165883	244835	8477226	0.508	4306431
2030	6251405	1343916	987890	207457	8375754	0.475	3978483
2031	6251405	1384234	803667	168770	8270536	0.444	3672118
2032	6251405	1425761	612996	128729	8161433	0.415	3386995
2033	6251405	1468534	415652	87287	8048304	0.388	3122742
2034	6251405	1512590	211400	44394	7931001	0.363	2878953
Total							79765100

PV of buying option = $79,765,100

Working Note:

Amount of mortgage = $90,000,000 - $18,000,000 = $72,000,000

Accordingly the amortization of mortgage will be as follows:

Year	Principal Outstanding at beginning	Annual mortgage	Interest	Principal	Principal Outstanding at end
2020	72000000	6251405	2520000	3731405	68268595
2021	68268595	6251405	2389401	3862004	64406591
2022	64406590.83	6251405	2254231	3997174	60409417
2023	60409416.5	6251405	2114330	4137075	56272341
2024	56272341.08	6251405	1969532	4281873	51990468
2025	51990468.02	6251405	1819666	4431739	47558729
2026	47558729.4	6251405	1664556	4586849	42971880
2027	42971879.93	6251405	1504016	4747389	38224491
2028	38224490.73	6251405	1337857	4913548	33310943
2029	33310942.9	6251405	1165883	5085522	28225421
2030	28225420.9	6251405	987890	5263515	22961906
2031	22961905.64	6251405	803667	5447738	17514167
2032	17514167.33	6251405	612996	5638409	11875758
2033	11875758.19	6251405	415652	5835753	6040005
2034	6040004.726	6251405	211400	6040005	0

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