Question: A motel leases out its 1,000-square-foot coffee shop, although it continues to own the equipment. The lease is due for renewal. The motel could continue to rent the space for $2 a square foot per month for the next 3 years, and then $2.50 a square foot for the following 2 years. Alternatively, the motel could cancel this lease and take over the operation of the restaurant. If this occurs, the motel's management estimates that sales revenue in the first year would be $700,000 and that it would increase by $50,000 per year for each of the following 4 years. Variable operating costs of running the restaurant (food cost, wages, supplies) would be 90% of sales revenue. The motel would also have to as sume certain other costs currently paid by the lessee for such items as supervision, advertising, and utilities.
These are estimated to be $32,000 in Year 1, increasing by $2,000 per year for each of the following 4 years, so that by Year 5 the costs will be $40,000. If the motel resumes operation of the restaurant, it will trade in some of the old equipment, for which it will get $5,000, and buy $40,000 of new equipment (this will not happen if the lease is renewed). The new equipment will have a 5-year life and would be depreciated on a straightline basis with no scrap value. The motel is in a 25% tax bracket. Use NPV to decide whether the motel should operate the coffee shop itself or continue to lease it out. Use a 10% discount rate.