Problem:
Florida Financial Consultants is expanding operations and the firm's president, Ms. Hillary Rose, is trying to make a decision about new office space. The following are Ms. Rose's options:
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Maple Commercial Plaza
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5,000 square feet; cost, $800,000; useful life, 10 years; salvage, $400,000
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High Tower
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20,000 square feet; cost, $3,400,000; useful life, 10 years; salvage, $1,500,000
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If the Maple Commercial Plaza is purchased, the company will occupy all of the space. If High Tower is purchased, the extra space will be rented for $620,000 per year. If purchased, either building will be depreciated on a straight line basis. For tax purposes, the buildings would be depreciated assuming a 25-year life. By purchasing either building, the company will save $210,000 annually in rental payments. All other costs of the two purchases (such as land cost) are expected to be the same. The firm's tax rate is 40 percent.
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 the cost of capital for
Florida Financial Consultants is 11 percent. Which purchase is the better investment based on the NPV method?
d. Ms. Rose is concerned about the ability to rent the excess space in High Tower for the 10-year period. To compute the NPV for that portion of the project's cash flows, she has decided to use a discount rate of 20 percent to compensate for risk. Compute the NPV and determine which investment is more acceptable.
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Project A
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Project B
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Investment
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$96,000
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$160,000
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After-tax cash flows
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$25,600
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$30,400
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Asset life
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6 years
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10 years
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a. Determine the net present value, profitability index, and internal rate of return for Projects A and B.
b. Using the answers to part (a), which is the more acceptable project? Why?
c. What is the Fisher rate for the two projects?