Question

You are considering the purchase of another office building close to your existing office building. The building is a 10-year old structure with an estimated remaining service life of 20 years. The tenants have recently signed long-term leases, 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 20% for every five-year interval over the remaining asset life. Thus, the annual rental income would be $240,000 for years 6 through 10, $288,000 for years 11 through 15, and $345,600 for years 16 through 20. You estimate that operating expenses will be $50,000 for the first year and that they will increase by $10,000 each year thereafter. You estimate that completely destroying the building and selling the lot on which it stands will realize a net amount of $250,000 at the end of the 20th year. If you had the opportunity to invest your money elsewhere and thereby earn interest at the rate of 15% per year, what would be the maximum amount you would be willing to pay for the building at the present time?

A. $772,056

B. $947,629

C. $817,976

D. $982,618

Answer 1

Correct Answer:

C

Working note:

R = 15%

Price to be paid for the building at present time = PW of annual income + PW of the resale value - PW of annual maintenance cost

Price to be paid for the building at present time = 200000*(P/A, 15%, 5) + 240000*(P/A, 15%, 5)*(P/F, 15%, 5) + 288000*(P/A, 15%, 5)*(P/F, 15%, 10) + 345600 *(P/A, 15%, 5)*(P/F, 15%, 15) +  250000*(P/F, 15%, 20) - (50000*(P/A, 15%, 20) + 10000*(P/G, 15%, 20))

Price to be paid for the building at present time = 200000*3.3522 + 240000*3.3522*.4972  + 288000*  3.3522
*.2472 + 345600 *3.3522 *.1229 +  250000*.0611 - (50000*6.259 + 10000*33.582)

Price to be paid for the building at present time = $817993.65  ( it is closest to alternative C)