West Coast Real Estate Management is expanding operations, and the firm’s president, Mike Mayberry, is trying to make a decision about new office space. The following are the firm’s options:
Maple Commercial Plaza .. 5,000 square feet; cost, $ 800,000; investment period, 10 years; salvage value in 10 years, $ 400,000
High Tower ........ 20,000 square feet; cost, $ 3,400,000; investment period, 10 years; salvage value in 10 years, $ 1,500,000
If Maple Commercial Plaza is purchased, West Coast Real Estate Management will occupy all of the space. If High Tower is purchased, West Coast Real Estate Management will rent the extra space for $ 620,000 per year. Both buildings will be depreciated on a straight-line basis for tax purposes using a 25-year life with no salvage value. Purchasing either building will save the company $ 210,000 annually in rental payments. All other costs of the two options (such as land cost) are expected to be the same. The firm’s tax rate is 40 percent. Either building would be sold after 10 years.
a. Determine the before-tax net cash flows from each project for each year.
b. Determine the after-tax cash flows from each project for each year.
c. Determine the net present value for each project if West Coast Real Estate Management’s cost of capital is 11 percent. Which purchase is the better investment based on the NPV method?
d. Mayberry questions whether the excess space in High Tower can be rented for the entire 10-year period. To compute the NPV for that portion of the project’s cash flows, he has decided to use a discount rate of 20 percent to compensate for risk. Compute the NPV and determine which investment is more acceptable.