Question

The Shamrock Inc., a manufacturer of low-sugar, low-sodium, low-cholesterol TV dinners, would like to increase its market share in the Sunbelt. In order to do so, Shamrock has decided to locate a new factory in the Panama City area. Shamrock will either buy or lease a site depending upon which is more advantageous. The site location committee has narrowed down the available sites to the following three very similar buildings that will meet their needs.

Building A: Purchase for a cash price of $612,300, useful life 26 years.

Building B: Lease for 26 years with annual lease payments of $70,170 being made at the beginning of the year.

Building C: Purchase for $652,900 cash. This building is larger than needed; however, the excess space can be sublet for 26 years at a net annual rental of $6,430. Rental payments will be received at the end of each year. The Shamrock Inc. has no aversion to being a landlord.


In which building would you recommend that The Shamrock Inc. locate, assuming a 11% cost of funds?

Answer 1

Here we need to compute present value of cost for each building.

Building A: PV = $612,300 (as the purchase price will have to be paid now)

Building B: As the payments are being done at the beginning of each year this is an annuity due. The variables are: rate = 11%; nper = 26, PMT = -70,170; FV = 0 and type = 1. The syntax will be: RATE (11%, 26, -70170, 0, 1). This gives a value of $661,123.82

Building C: present value of annual rentals = PV (11%, 26, 6430, 0, 0). This gives a value of rentals = 54,578.21

Thus net cost here = 652,900 - 54,578.21 = $598,321.79

Thus Shamrock Inc. should purchase building C as it is in this case that the present value of net costs/net amount paid is the lowest.