Question

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 outof-pocket expenses each period.

Property taxes (to be paid at the end of each year) \)40,000

Insurance (to be paid at the beginning of each year) 27,000

Other (primarily maintenance which occurs at the end of each year) 16,000

\(83,000

Lease: First National Bank has agreed to purchase the site, construct the building, and install the appropriate fi xtures for Dunn Inc. if Dunn will lease the completed facility for 12 years. The annual costs for the 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 payment to 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 fixtures.

Instructions Which of the two approaches should Dunn Inc. follow? (Currently, the cost of funds for Dunn Inc. is 10%.)

Short answer

The company should take the building on lease.

Step-by-step solution

Computation of present value of buying

$\begin{array}{rcl}\mathrm{Cost}\mathrm{of}\mathrm{buying}& =& \mathrm{Downpayment}+\mathrm{PV}\hspace{0.17em}\mathrm{of}\mathrm{annual}\mathrm{installment}+\mathrm{PV}\hspace{0.17em}\mathrm{of}\mathrm{annual}\mathrm{tax}+\mathrm{PV}\hspace{0.17em}\mathrm{of}\mathrm{annual}\mathrm{insurance}\mathrm{payment}-\mathrm{PV}\mathrm{of}\mathrm{sale}\mathrm{value}\\ & =& 40,000+350,000\times \left(1-\left(1+10{\%}^{-5}\right)\right)+\left(40,000+16,000\right)\times \left(1-\left(1+10{\%}^{-12}\right)\right)/10\%\\ & =& \$2,151,393.50\end{array}$

Computation of present value of cost of leasing

$\begin{array}{rcl}\mathrm{Cost}\mathrm{of}\mathrm{leasing}& =& \mathrm{Initial}\mathrm{deposit}+\mathrm{PV}\mathrm{of}\mathrm{annual}\mathrm{payment}-\mathrm{PV}\hspace{0.17em}\mathrm{of}\mathrm{deposit}\mathrm{refund}\\ & =& 100,000+270,000\times \left(1-1+10{\%}^{-12}\right)/10\%\times \left(1+10\%\right)-\frac{100,000}{\left(1+10{\%}^{12}\right)}\\ & =& \$2,091,803.39\end{array}$

The company should take the building on lease as its present value of cost is lower than buying.