Dear Texas Bob,
The calculations made were based on formulas we deem fit. In obtaining the income, we used the cash flow method, which is simply the difference between the cash that flows in versus the cash that flows out of the business. That method would prove to be more accurate since in the retail food industry, cash is considered king.
Likewise, we discounted the values using the present value formula. We deem it important that the time value of money shall be considered to accurately reflect the amounts, not in a nominal sense, but in its real sense.
Lastly, we also considered the externality and the possible business opportunities that can be made given the option to be chosen
Sincerely,
Option 1 Lease:
Leasing a property has certain advantages over purchasing it. Since a lease is paid in instalments, it does not require a loan which in turn shall require periodic interest payments. A lease, as compared to other real property options does not require a huge cash outflow (E finance Management). Moreover, restaurant owner will not be mandated to pay property taxes.
In the case above, the lease shall be for 10 year period, amounting to $15 per square foot. To obtain the lease amount, the price per square foot shall be multiplied with the size of the property. Thus, the monthly amount which has to be paid for the lease is $116,250.00. Such will be a recurring cost, regardless of whether the business has positive income or not.
In the first year of operations, the business will have a negative cash flow of $27,750. This will be because of the fitting out worth $350,00 which is considered a sunk cost. Sunk costs are expenses that have been incurred for the business regardless of its profitability (Accounting Tools). These are cash outflows which are required on a one-time basis, and which cannot be recaptured.
Although the first year of operations given in option 1 has a negative outflow, the succeeding years will register a positive income stream. Among the expenses, the overhead expense carries the largest portion of the costs. The overhead expense is 13% of the sales generated. Meanwhile, the operating expense is 1.19% of the sales. On one hand, the periodic lease payments is equivalent to 3.29% of the total sales generated
Over a 10 year period, the business will net an after tax income of $3.7 million.
In obtaining the after tax income of the first option, which is the lease, the revenue first has to be determined. The revenue is the amount of cashflow into the company. It consists of the difference between the sales generated, which is a positive flow, less the cost of the goods sold, a negative flow.
After which, the expenses required in running the business shall be taken into consideration. This includes overhead expenses, costs which are classified as fixed. Fixed costs are to be incurred regardless of the volume or amount of goods to be sold. This is in contrast to variable costs, which are dependent on the value of the goods or products to be disposed of.
However, to actually compare and see the value of the investment, the net present value of the activity has to be considered. The net present value discounts the current income with the inflation rate. Taking inflation into account, the nominal increase can thus be attributed to actual changes in the demand or the sales generated. The net present value formula is thus computed as the sum of the present values of the annual income. The present value meanwhile is as follows: Income/(1+inflation)^t, where t is the time period where the income has been generated (Gallo).
In the above computation, given the 10 year period, the project has a net present value of $3.14 million. The positive net present value indicates that the option is financially viable.
Another method to consider is the return on investments. The only cost to be incurred in the lease option is the expense to be paid for the fitting of the restaurant. In the above calculations, the lease option would have an ROI of 898%.
Option 2 – Purchase
Aside from the option to lease the property, the business is looking to purchase the area involved, given the current decrease in the price of real estate. Purchasing the property outright provides certain advantages.
One advantage is that the property shall be owned by the business itself. It can be a viable investment, should the price be right. Likewise, should the business not work out financially, the real estate can be leased, or perhaps resold at a profit.
Given the price of $90 per square foot of the area, the owner has to pay $0. 697M to be able to obtain said property. Such shall then be considered as a sunk cost (Investopedia, 2016). Whether or not the management decides to pursue the business or otherwise, the cost has already been incurred.
Moreover, to finance the purchase, the company has to take out a loan. The current treasury rates are at 1.95%, and given a premium of 350 basis points, the interest rate for the loan shall be at 5.9%.
Since the loan shall be amortized on a 30 year period, the compounding shall increase the actual nominal amount which has to be repaid. Instead of the clean amount of the property, which is $0. 697 million, the property will actually be worth $3.378 million. The calculation was obtained by multiplying the property’s purchase price with the interest rate, 30 times, which is the period of payment.
Since the amount will be repaid in a thirty year term , the nominal loan shall then be divided by the period. The annual amortization which has to be paid is then equal to $112k.
Another caveat of the loan is that the property has to be mortgaged. A mortgage allows the lender, which is the financial institution in this case to be secure, should the debtor be unable to pay in the future. Depending on the terms of the agreement, the lender may have an option of owning the property if a lapse in payment in the debtor’s side shall occur.
In the first year of operations, the company will incur a negative cash flow. The outlay will largely be made for the purchase of the property. Additionally, the fitting out shall be made, regardless of whether the property shall be leased or purchased. The amount of $730K will thus be an outflow for the first year.
On the second year however, and moreso on the succeeding years, the business will register a positive cashflow. Option 2, which is the choice to purchase the property will yield the business a nominal amount of $3.753, after tax.
However, since nominal amounts mean nothing except when discounted to their real amounts, then the present value analysis in this case would be of more significance. The nominal cash flow from the business operations must be realized in terms of its real value. To obtain the real value, the income must be discounted by the inflation rate, or the CPI which is 2.5% annually. For a ten year period, thus, the net present value for option 2 will be $3.542M.
Externalities
Payment of taxes are considered an expense, thus it has to be deducted from the taxable income of the company.However, since the depreciation rate is 25%, the property shall be depreciated in a 5 year term. After 5 years, the property is considered as fully depreciated in the books of the company.
Given that the company shall be required to pay property taxes, thus the cash flow of option 2 will now be lower. The tax to be paid shall be deducted from the earnings, likewise lowering the taxable income too. Note once again that the tax for the property shall end after 5 years. After such time, the property is considered to have been fully depreciated. Thus, the business would not be required to pay property taxes.
On one hand, the land shall have a salvage value. The salvage value is the amount that shall be received by the company should it decide to sell the land. In the sixth year for instance, the property will be worth $920k, should the company decide to sell it at that time. Deducting the acquisition cost, it may seem that the company will recognize a profit from the sale. In this case, 920,336-697,500= 222,836.
However, such amount does not take into account the actual costs incurred for the property. Aside from the acquisition cost, the actual loan taken out by the company, along with the taxes incurred have to be likewise considered. In doing so, it will be more viable should the company decide to sell it a later time.
The total amount of taxes paid for the property amounts to $783K. Since the loan shall be amortized over a thirty year period, the total amount which includes compounded interest have to be discounted to its present value. Compared to the total amortizations paid which is $3.378million, the net present value of the loan is actually $3.338 million. Thus, taking into account the acquisition cost which is to be paid at time 0, the net present value of the tax which is $724K and the net present value of the loan, $ 3.338m, the break even value of the property is actually $3.366 million. Such is the amount that the property has to be sold to be able to totally and really recoup the expenses.
Comparison of Option 1 and Option 2
In deciding on which option to be considered, not only should the financial impact of the decision has to be considered, but the externalities as well. For option 1, the lease as compared to the purchase would entail a periodic irrecoverable cost annually. The business has to pay for the rent, whether or not it is making money, regardless of the volume of the goods sold. However, as a lessee, it is not burdened with the payment of property taxes. Another advantage of having a lease is that, the company may pre-terminate the contract, provided the penalty is not usurious. It can opt out of the lease and of the business, if through time, it will prove to be financially non-viable.
In leasing a property, since the lessee is not considering holding the property for a long time, he has the option of choosing quality locations. He is not constrained with owning the property, thus he can have more flexibility, especially in terms of the property’s aesthetics.
On another hand, should the property be purchased, as can be gleaned from the considerations above, the owner has to pay taxes consistently. Moreover, a loan has to be obtained to pay for the property outright. The calculations have shown that the loan with a compounded interest of 5.9% annually exponentially increase the sunk cost of the land. Given that inflation is only 2.5%, the interest premium that has to be paid is twice the actual cost of money.
Thus, from the calculations made, it can be said that although purchasing a property may seem and may sound a good choice, it is not a financially sound one, taking into account the taxes, the loan interest expense and the very long break even point where the property may be sold to recoup the expenses incurred.
On another note, purchasing a property may likewise be a good option should the company opt to develop the area. Instead of solely using the property as a restaurant, the company may build a high rise building and lease out the property to tenants with complementary businesses.
For instance, in the case above, the company may consider developing the property and allowing lessees such as coffee shops and offices to occupy the high rise development. In that case, the business will have a capture market, those who reside near the restaurant.
Works Cited
Accounting Tools. б.д. http://www.accountingtools.com/questions-and-answers/what-is-a-sunk-cost.html. 15 April 2016 r.
E finance Management. б.д. https://www.efinancemanagement.com/sources-of-finance/advantages-and-disadvantages-of-leasing. 15 April 2016 r.
Gallo, Amy. Harvard Business review. 19 november 2014 r. https://hbr.org/2014/11/a-refresher-on-net-present-value. 15 April 2016 r.
Investopedia. 2016. 26 January 2016 r. <http://www.mylawyer.com.my/pdf/Wills_Act.pdf>.
