Construct a Facility vs. Leasing Decision

Today is January 1, 2019. You have just discovered a natural spring on your property, and have decided to start a Bottled Water Company. As a result, you are in need of acquiring the use of a bottling facility. However, you are uncertain of whether your idea will be a success, and thus are trying to decide whether leasing or buying the bottling facility and equipment makes sense.

The possible options are as follows:

Construct a Bottling Facility

You can build a bottling facility, including the bottling equipment, near your natural spring at a cost of $ 1,000,000. While you dont have $ 1,000,000, a bank is willing to loan you $ 800,000 as long as you make a $ 200,000 down payment on the building.

The terms of the bank loan are that you would be required to make a total of five equal annual payments, with the first payment due on December 31, 2019 and the last annual payment due on December 31, 2023. The amount owed to the bank after the last payment will be $ 0. The bank will charge you an interest rate of 10% on their loan, and the interest component of your payments would be deductible for tax purposes.

For income tax purposes, the bottling facility and equipment would be considered

10-Year Property, and will be depreciated according to the schedule found on the last page of this exam. At the end of ten years, the bottling equipment will be worthless and in need of replacement. However, you do expect that the facility itself will have value, and you believe that you could sell the facility for $ 400,000 at the end of ten years.

The bottling facility referenced above has a capacity of 2,000,000 bottles of water per year, which is identical to the capacity available at the facility described below.

Lease a Bottling Facility

A local soda manufacturer just went out of business. As a result, the owner of their bottling facility is looking for a new tenant, and he has offered you the opportunity to lease his bottling facility at a rate of $ 90,000 per year. He is willing to offer you a five year lease at that rate, with an option to renew for another five years at a rate of

$ 125,000 per year. Any lease payments would be due at the beginning of the respective year. Unfortunately, the owner of the facility has told you that at the end of ten years, a new highway will be built through the site of this bottling facility. Therefore, at the end of ten years, you will have to find another location to bottle your water.

One drawback of leasing the existing bottling facility is that you would have to hire a trucking company to transport your spring water to the bottling facility. A local trucking firm has offered to do this for you at a price of 5 cents per bottle. They will agree to transport any volume of water at this price, with a minimum of 100,000 bottles per year. The trucking firm is willing to sign this agreement for five years, and will give you the option to renew under the same terms for another five years at the end of the fifth year.

All lease payments should be considered tax deductible at the end of the year in which the payment is made. For example, a lease payment made on January 1, 2019 would be deductible for the year ending December 31, 2019. The transportation expenses for trucking your water would also be deductible at the end of the year in which they were incurred.

Other Information

Assume that your company will be very profitable, and that you pay taxes at a rate of 40% per year. Assume that this rate applies to all types of income ordinary income, capital gains, etc., and that you receive a tax refund calculated using this rate if you have a capital loss. Unless indicated otherwise, assume that you plan on producing

1,200,000 bottles of water each year. Assume that Bottled Water Company adopted Accounting Standards Update 2016-02 on January 1, 2019.

Instructions

(A) If you plan on staying in business for ten years, and if your cost of capital

is 10%, should you construct your own bottling facility, or lease the one

described above? You must support your answer to receive credit.

(B) Under 2019 US GAAP, from a financial reporting perspective, would the

lease of the bottling facility under the proposed terms be an operating lease

or a finance lease? Why?

(C) Regardless of whether you determined that leasing the bottling facility

was the optimal decision, suppose that you have decided to lease the bottling

facility. At what amount would the Lease Liability appear on your

December 31, 2019 Balance Sheet? What is the total expense that you would

report related to the lease for the year-ending December 31, 2019?

(D) Assuming that you remain in business for all ten years, is this decision

sensitive to your expected production capacity each year? In other words, if

you planned on producing at some other capacity other than 1,200,000, would

your decision change? (Assume production volume is the same each year.)

(E) Suppose that you are uncertain of whether you want to remain in

business after the fifth year. If you build a facility and decide to shut down

your operations at the end of five years, you may assume that you can sell the

bottling facility for $ 600,000. Alternatively, if you are leasing the facility,

you may decide to not renew the lease for the additional five years.

Based on this information, is the renewal option (i.e. the option to renew

or terminate the lease at the end of five years) valuable? Why or why not?

For purposes of this question, valuable means relative to a lease in which

you were obliged to pay $ 90,000 for five years and $ 125,000 for years six

through ten with no option to terminate the lease at the end of five years.