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Chapter 6: Question 12E (page 304)

The Black Knights Inc., a manufacturer of low-sugar, low-sodium, low-cholesterol TV dinners, would like to increase its market share in the Sunbelt. In order to do so, Black Knights has decided to locate a new factory in the Panama City area. Black Knights will either buy or lease a site depending upon which is more advantageous. The site location committee has narrowed down the available sites to the following three very similar buildings that will meet their needs. Building A: Purchase for a cash price of \(600,000, useful life 25 years. Building B: Lease for 25 years with annual lease payments of \)69,000 being made at the beginning of the year. Building C: Purchase for \(650,000 cash. This building is larger than needed; however, the excess space can be sublet for 25 years at a net annual rental of \)7,000. Rental payments will be received at the end of each year. The Black Knights Inc. has no aversion to being a landlord

Instructions In which building would you recommend that The Black Knights Inc. locate, assuming a 12% cost of funds?

Short Answer

Expert verified

The best recommendation to The Black Knight Inc. is to locate to building C.

Step by step solution

01

Building A and Building B

Building A = $600,000

BuildingBleaseprice=Annualleasepayment脳PVfactorofannuitydue=69,000脳8.78432=$606,118

02

Building C

BuildingC=Purchaseprice-(Rent脳PVfactorofannuitydue)=650,000-(7,000脳7.84314)=$595,098.02

The best alternative is building C as the PV of its net cost is the smallest.

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Most popular questions from this chapter

Assume that Wal-Mart Stores, Inc. has decided to surface and maintain for 10 years a vacant lot next to one of its stores to serve as a parking lot for customers. Management is considering the following bids involving two different qualities of surfacing for a parking area of 12,000 square yards.

Bid A: A surface that costs \(5.75 per square yard to install. This surface will have to be replaced at the end of 5 years. The annual maintenance cost on this surface is estimated at 25 cents per square yard for each year except the last year of its service. The replacement surface will be similar to the initial surface.

Bid B: A surface that costs \)10.50 per square yard to install. This surface has a probable useful life of 10 years and will require annual maintenance in each year except the last year, at an estimated cost of 9 cents per square yard.

Instructions Prepare computations showing which bid should be accepted by Wal-Mart. You may assume that the cost of capital is 9%, that the annual maintenance expenditures are incurred at the end of each year, and that prices are not expected to change during the next 10 years.

During the past year, Stacy McGill planted a new vineyard on 150 acres of land that she leases for \(30,000 a year. She has asked you, as her accountant, to assist her in determining the value of her vineyard operation.

The vineyard will bear no grapes for the first 5 years (1鈥�5). In the next 5 years (6鈥�10), Stacy estimates that the vines will bear grapes that can be sold for \)60,000 each year. For the next 20 years (11鈥�30), she expects the harvest will provide annual revenues of \(110,000. But during the last 10 years (31鈥�40) of the vineyard鈥檚 life, she estimates that revenues will decline to \)80,000 per year.

During the first 5 years, the annual cost of pruning, fertilizing, and caring for the vineyard is estimated at \(9,000; during the years of production, 6鈥�40, these costs will rise to \)12,000 per year. The relevant market rate of interest for the entire period is 6%. Assume that all receipts and payments are made at the end of each year.

Instructions Dick Button has offered to buy Stacy鈥檚 vineyard business by assuming the 40-year lease. On the basis of the current value of the business, what is the minimum price Stacy should accept?

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Danny鈥檚 Lawn Equipment sells high-quality lawn mowers and offers a 3-year warranty on all new lawn mowers sold. In 2017, Danny sold \(300,000 of new specialty mowers for golf greens for which Danny鈥檚 service department does not have the equipment to do the service. Danny has entered into an agreement with Mower Mavens to provide all warranty service on the special mowers sold in 2017. Danny wishes to measure the fair value of the agreement to determine the warranty liability for sales made in 2017. The controller for Danny鈥檚 Lawn Equipment estimates the following expected warranty cash outflows associated with the mowers sold in 2017.

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Instructions Using expected cash flow and present value techniques determine the value of the warranty liability for the 2017 sales. Use an annual discount rate of 5%. Assume all cash flows occur at the end of the year.

For each of the following, determine the expected cash flows. Cash Flow Probability Estimate Assessment (a) \( 4,800 20% 6,300 50% 7,500 30% (b) \) 5,400 30% 7,200 50% 8,400 20% (c) $(1,000) 10% 3,000 80% 5,000 10%
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