Question

A company is planning to move to a larger office and is trying to decide if the new office should be owned or leased. Cash flows for owning versus leasing are estimated as follows. Assume that the cash flows from operations will remain level over a 10 year holding period. If purchased, the company will invest $385,000 in equity and finance the remainder with an interest-only loan that has a balloon payment due in year 10. The after-tax cash flow from sale of the property at the end of year 10 is expected to be $750,000. What is the incremental rate of return on equity to the company, if the property is owned instead of leased?
Own Lease
Sales 1,000,000 1,000,000
Cost of goods sold 500,000 500,000
Gross income 500,000 500,000
Operating expenses:
Business 130,000 130,000
Real estate 60,000 60,000
Lease payments 0 120,000
Interest 90,000 0
Depreciation 35,000 0
Taxable income 185,000 190,000
Tax 55,500 57,000
Income after tax 129,500 133,000
Plus: Depreciation 35,000 0
After-tax cash flow 164,500 133,000

(A) 17.99%
(B) 13.26%
(C) 10.32%
(D) 12.62%

Answer

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