High Street Stores operates a chain of superior-quality department stores. The company is going to open another store soon in a prosperous and growing suburban area.
In discussing how the company can acquire the desired building and other facilities needed to open the new store, Jim Davis, the company's marketing vice-president, met with Corinna Albrecht, the company's executive vice-president. Here is an exchange from that meeting:
Davis stated, "I know most of our competitors are starting to lease facilities, rather than buy, but I just can't see the economics of it. Our development people tell me that we can buy the building site, put a building on it, and get all the store fixtures we need for $14 million. They also say that property taxes, insurance, maintenance, and repairs would run $200,000 a year. When you figure that we plan to keep a site for 20 years, that's a total cost of $18 million. But then when you realize that the building and property will be worth at least $5 million in 20 years, that' s a net cost to us of only $13 million. Leasing costs a lot more than that."
"I'm not so sure," replied Albrecht. "Guardian Insurance Company is willing to purchase the building site, construct a building, and install fixtures to our specifications, and then lease the facility to us for 20 years for an annual lease payment of only $1 million."
"That's just my point," said Davis. "At $1 million a year, it would cost us $20 million over the 20 years instead of just $13 million. What would we have left at the end? Nothing! The building would belong to the insurance company! I'll bet they would even want the first lease payment in advance."
"That's right," replied Albrecht. "We would have to make the first payment immediately and then one payment at the beginning of each of the following 19 years. However, you're overlooking a few things. For one thing, we would have to tie up a lot of our funds for 20 years under the purchase alternative. We would have to put $6 million down immediately if we buy the property, and then we would have to pay the other $8 million off over four years at $2 million a year."
"But that cost is nothing compared to $20 million for leasing," said Davis. "Also, if we lease, I understand we would have to put up a $400,000 security deposit that we wouldn't get back until the end. Besides that, we would still have to pay all of the repair and maintenance costs as if we owned the property. No wonder those insurance companies are so rich if they can swing deals like this."
"Well, I'll admit that I don't have all the figures sorted out yet," replied Albrecht. "But I do have the operating cost breakdown for the building, which includes $90,000 annually for property taxes, $60,000 for insurance, and $50,000 for repairs and maintenance. If we lease, Guardian will handle its own insurance costs and will pay the property taxes, but we'll have to pay for the repairs and maintenance. I need to put all this together and see if leasing makes any sense with our 12% before-tax required rate of
return. The president wants a presentation and recommendation in the executive committee meeting tomorrow."
Required:
1) Using the net present value approach, determine whether High Street Stores should lease or buy the new store. Assume that you will be making your presentation before the company's executive committee.
2) How will you reply in the meeting if Jim Davis brings up the issue of the building's future sales value?