Question

Your firm is considering purchasing an old office building with an estimated remaining service life of 25 years. Recently, the tenants signed a long-term lease, which leads you to believe that the current rental income of $200,000 per year will remain constant for the first five years. Then the rental income will increase by 10% for every five-year interval over the remaining life of the asset. That is, the annual rental income would be $220,000 for years 6 through 10, $242,000 for years 11 through 15, $266,200 for years 16 through 20, and $292,820 for years 21 through 25. You estimate that operating expenses, including income taxes, will be $90,000 for the first year and that they will increase by $5,000 each year thereafter. You also estimate that razing the building and selling the lot on which it stands will realize a net amount of $60,000 at the end of the 25-year period. If you had the opportunity to invest your money elsewhere and thereby earn interest at the rate of 12% per annum, what would be the maximum amount you would be willing to pay for the building and lot at the present time?

Answer 1

The maximum amount that a person willing to pay for this building can be calculated with the help of the Net Present Value method. The NPV amount is the maximum amount that a person will be willing to pay.

NPV= present value of cash inflow- the present value of cash outflow

Cash inflow throughout 25 years:

• Period 1- 5 - $200,000
• Period 6- 10- $220.000
• Period 11- 15- $242,000
• Period 16- 20- $266,200
• Period 21- 25- $292,820 and $60,000 in 25th year

Cash outflow throughout 25 years:

• Period 1: $90,000
• Then in each period an addition $5,000 upto 25th year

Required rate of return= 12%

Present value of cash inflow=

=$1740097.453

Present value of cash outflow=

= $977970.806

NPV= $1740097.453- $977970.806= $762126.6464

So $762126.6464 is the maximum amount

Good luck!!

Please do hit the thumbs up if you like the answer