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Should Top-Quality Stores Inc. Lease or Buy a New Facility?

Task

Top-Quality Stores Inc. owns a nationwide chain of supermarkets. The company is going to open another store soon, and a suitable building site has been located in an attractive and rapidly growing area. In discussing how the company can acquire the desired building and other facilities needed to open the new store, Sam Watkins, the company’s vice-president in charge of sales, 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 just $850,000. They also say that property taxes, insurance, and repairs would run $20,000 a year. When you figure that we plan to keep a site for 18 years, that’s a total cost of $1,210,000. But then when you realize that the property will be worth at least a half million in 18 years, that’s a net cost to us of only $710,000. What would it cost to lease the property?”

“I understand that Beneficial 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 18 years at an annual lease payment of $120,000,” replied Lisa Coleman, the company’s executive vice-president.

“That’s just my point,” said Watkins. “At $120,000 a year, it would cost us a cool $2,160,000 over the 18 years. That’s three times what it would cost to buy, and what would we have left at the end? Nothing! The building would belong to the insurance company!”

“You’re overlooking a few things,” replied Coleman. “For one thing, the treasurer’s office says that we could only afford to put $350,000 down if we buy the property, and then we would have to pay the other $500,000 off over four years at $175,000 a year. So there would be some interest involved on the purchase side that you haven’t figured in.”

“But that little bit of interest is nothing compared with over two million bucks for leasing,” said Watkins. “Also, if we lease, I understand we would have to put up an $8,000 security deposit that we wouldn’t get back until the end. And besides that, we would still have to pay all the yearly repairs and maintenance costs just like 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 Coleman. “But I do have the operating cost breakdown for the building, which includes $7,500 annually for property taxes, $8,000 for insurance, and $4,500 for repairs and maintenance. If we lease, Beneficial will handle its own insurance costs, and of course the owner will have to pay the property taxes. I’ll put all this together and see if leasing makes any sense with our required rate of return of 16%. The president wants a presentation and recommendation in the executive committee meeting tomorrow. Let’s see, Development said the first lease payment would be due now and the remaining ones due in years 1 to 17. Development also said that this store should generate a net cash inflow that’s well above average for our stores.”

1. Using the NPV approach, determine whether Top-Quality Stores Inc. should lease or buy the new facility. Assume that you will be making your presentation before the company’s executive committee, and remember that the president detests sloppy, disorganized reports.

2. What reply will you make in the meeting if Watkins brings up the issue of the building’s future sales value?

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