Platt Enterprises started a wholesale business two years ago and has made a profit from the beginning. To date, the company has been storing merchandise inventory in a public warehouse, but the business has grown to a point where this policy is now cumbersome.
The company expects to enjoy unusually rapid growth for the next five years until it achieves a steady market share. Platt is seeking to acquire warehouse space for its exclusive use that will carry it through the growth period. After five years, it intends to obtain a more permanent space designed and built for its own specific needs.
A suitable site has been found that will meet Platt’s needs for the next five years. The owner of the property has given Platt two options. Under the first of these, Platt would purchase the land and building for $200,000 ($50,000 for land, $150,000 for the building). Under the second, Platt would lease the land and building for five years at an annual rent equal to 11% of the property’s current value ($200,000).The lease would be a net lease requiring Platt to pay for all operating costs associated with the property, including property taxes, insurance, utilities, and maintenance.
The company is having difficulty choosing between the two options. The rental rate of 11% of the property’s value does not seem excessive, considering that the company can borrow funds at 10% (it currently has no major debt). In fact, there are sufficient cash resources to purchase the property with cash. The purchase option also appears attractive, even though the land and building will have to be sold at the end of five years. In particular, the company is aware that recent studies of the local real estate market predict that warehouse properties will increase in value at the rate of 5% annually for the next eight years.
Platt realizes that the same issue will have to be examined again in five years. A local real estate developer who is planning a long-term industrial real estate development is aware of Platt’s five-year plan. The developer has indicated that it is prepared to design and construct a building for Platt that will be ready by the end of the five-year period. The developer has also indicated that a group of investors wants to own the proposed property and lease it to Platt under a long-term lease arrangement. Of course, Platt could also choose to own the future property. Platt Enterprises is subject to a 25% tax rate.
Required:
1. Prepare an analysis, and advise Platt Enterprises as to which option is most advantageous. You may assume that the future property needed after five years will be obtained through the lease arrangement suggested by the developer.
2. To what extent, if any, would your decision be affected if it were assumed that the future property needed after five years will be purchased by Platt, rather than leased?