Question

In 2016, Flounder Enterprises negotiated and closed a long-term lease contract for newly constructed truck terminals and freight storage facilities. The buildings were constructed on land owned by the company. On January 1, 2017, Flounder took possession of the leased property. The 20-year lease is effective for the period January 1, 2017, through December 31, 2036. Advance rental payments of $773,000 are payable to the lessor (owner of facilities) on January 1 of each of the first 10 years of the lease term. Advance payments of $391,000 are due on January 1 for each of the last 10 years of the lease term. Flounder has an option to purchase all the leased facilities for $1 on December 31, 2036. At the time the lease was negotiated, the fair value of the truck terminals and freight storage facilities was approximately $7,454,000. If the company had borrowed the money to purchase the facilities, it would have had to pay 9% interest.

Compute the present value of lease vs purchase.

Answer 1

Answer:

Present Value of Cash Outflow under purchase option is as given in the question $ 7,454,000

Present Value of Cash Outflows under Lease Option can be calculated by discounting the 20 years lease rental payments using the discounting factors for 9% as cost of capital. The calculations are as follow;

Discounting Factor for 1st 10 years = [(1/1.09)^1 + ....... + (1/1.09)^10] = 6.14765

Discounting Factor for 11th to 20th year = [(1/1.09)^11 + ....... + (1/1.09)^20] = 2.71088

So, the Present Value of Cash Flows under Lease Payment = $ 773,000 * 6.14765 + $ 391,000*2.71088 = $ 6,020,806.598 or $ 6,020,807