Arnold Enterprises is evaluating alternative uses for a three-story manufacturing and warehousing building that it has purchased for $800,000. The company can continue to rent the building to the present occupants for $20,000 per year. The present occupants have indicated an interest in staying in the building for at least another 10 years. Alternatively, the company could modify the existing structure to use for its own manufacturing and warehousing needs. Arnolds production engineer feels the building could be adapted to handle one new product line. The cost and revenue data for the product line are as follows:
Initial cash outlay for building modifications $50,000
Initial building outlay for equipment $150,000
Annual pretax revenues (generated for 15 years) $120,000
Annual pretax expenditures (generated for 15 years) $60,000
The building will be used for only 10 years. After 10 years the building will be too small for efficient production. At that time, Arnold plans to rent the building to firms similar to the current occupants. To rent the building again, Arnold will need to restore the building to its present layout. The estimated cash cost of restoring the building is $20,000. The cash cost can be deducted for tax purposes in the year the expenditures occur. Arnold will depreciate the original building shell (purchased for $800,000) over a 20-year life to zero, regardless of which alternative it chooses. The building modifications and equipment purchases are estimated to have a 10-year life. They will be depreciated by the straight-line method. The firms tax rate is 30 percent, and its required rate of return on such investments is 10 percent. For simplicity, assume all cash flows occur at the end of the year. The initial outlays for modifications and equipment will occur today (year 0), and the restoration outlays will occur at the end of year 10. Which use of the building would you recommend to management?