Jensen Company owns a building in a suburban industrial park. It purchased the building four years ago for $3 million. It is now deciding whether to lease the building or to use it as a distribution center. It could be rented immediately. Given today’s market conditions, rental income of $120,000 per year would be expected. To convert the building to make it useful as a distribution center would require an immediate expenditure of $400,000. Having the distribution center at this location would provide Jensen with $140,000 per year in cost savings, at today’s prices. The cash flows associated with this decision are not very risky, so a real discount rate of just 3% per year is required.
For simplicity, assume that: (i) there are no taxes, (ii) the building could be rented or used as a distribution center forever, (iii) ongoing cash flows, including rents and distribution cost savings, would increase with the overall inflation rate, and (iv) all cash flows except the initial $400,000 would occur at year end. (the last assumption implies that one year of inflation would affect the first lease payment and distribution cost saving)
a. The inflation rate is forecast to be 4% per year. What nominal discount rate is appropriate for this project?
b. Provide a NPV analysis and a recommendation of how the building should be used.
c. Is the outcome of your NPV analysis sensitive to changes in the assumed inflation rate? (An intuitive answer without numbers is OK).
Based on the information provided, is it possible to estimate the current market value of the building? If so, provide an estimate.