QUESTION
This case is a straightforward valuation exercise using the weighted average cost of capital to calculate the net present value of a project. As such, it could be incorporated in a number of different courses, ranging from an introductory course in financial management, to a finance course in valuation or a real estate course in valuation. The case can be viewed as a “lease” versus “buy” decision. There are three options available to FNB:
(1) Continue to rent.
(2) Buy existing building and continue to lease existing and additional office space.
(3) Build a new building
To calculate incremental cash flows, we need a “base case.” Assume that the base case is to simply continue to rent. This implies that options 2 and 3 will have positive incremental cash flows equal to the rent that would have been paid under option 1.
One page memo identifying the ten rubrics. Four deal with the proper calculation of cash flows for the three options available to FNB. Four deal with proper calculation of the WACC for discounting the cash flows. Two deal with the qualitative aspects of the case that cannot easily be addressed by NPV/WACC.
The spread sheet(s) with valuations will need to be included as an excel spreadsheet
ANSWER
Lease or Buy Decision Making FNB Bancorp
Computation of cash outflow in 3 options
- Option-1 – Renting and leasing the space required
As per the data provided the PV of option to rent and lease entails a cash outflow of $ 2,76,72,271.75 in present value terms up to 2014 starting from 2000.
- Option-2 Buying Class A and renting the rest space
As per the given information about buying the space and renovating it, the PV of construction and renting netted off with the PV of terminal value and rent inflow is found to be $ 1,05,90,502.38
Option-3 Buying the high raiser building
As per the given data the PV of construction of building netted off with the depreciation tax saving, terminal value and rent received forms to be -$ 13,03,20,193.28
Estimation of terminal Value
The terminal value was considered as the capitalised value i.e. for option-2 $ -96800039.72 and for option-3 $ 23,75,86,639.69
Computation of WACC
- Rate of Risk Free return
Since the case in hand has the life of nearly 10 years the Rf is taken as 10-year Treasury Bond Rate i.e. 6.50%
- Beta
De-levering the beta with the debt equity ratio of FNB, which was found by considering debt value of 8.1 billion and market value of equity, came to 0.45. Therefore Levered Beta of FNB as a REIT using the given tax rate was found to be 1.034
- Cost of equity
As per capital asset pricing model, the cost equity using the data above and a historical market return was found to 15.18%
- WACC
Using the average rate of debt on market value of debt I.e. 6.56% and considering weighted average of Equity and Debt the cost of Capital is computed as 10.78%
Incremental Cash flows
Taking option 1 as Base, none of the option gave in positive cash flows in present value terms. Considering option 2 over 1 will have a saving $ 1,01,24,985.76 impact and whereas considering option 3 over 2 will have a saving of $ 16,18,01,715.25 impact over the cash position of FNB in present value terms.
FNB shall go with 3rd option of constructing a high raiser as it will lead to highest saving.
Option 1 | ||
Class A office at 420 main street | 109000 | sq ft |
Rent per sq feet till 2004 | 10 | |
Life of lease-initial | 10 | |
Rent per sq feet from 2004 | 26 | |
class c office space | 27000 | sq ft |
Rent per sq feet till 2004 | 9 | |
Rent per sq feet from 2004 | 13 | |
new rented space per year | 10000 | sq ft |
current rent | 13 | |
increment | 2% | |
1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 | 11 | 12 | 13 | 14 | 15 | |
2000 | 2001 | 2002 | 2003 | 2004 | 2005 | 2006 | 2007 | 2008 | 2009 | 2010 | 2011 | 2012 | 2013 | 2014 | |
Option -1 | |||||||||||||||
Class A office | 1090000 | 1090000 | 1090000 | 2948493.6 | 3007463.472 | 3067612.74144 | 3128964.9962688 | 3191544.29619418 | 3255375.18211806 | 3320482.68576042 | 3386892.33947563 | 3454630.18626514 | 3523722.78999045 | 3594197.24579025 | 3666081.19070606 |
Class C office | 243000 | 243000 | 243000 | 365180.4 | 372484.008 | 379933.68816 | 387532.3619232 | 395283.009161664 | 403188.669344897 | 411252.442731795 | 419477.491586431 | 427867.04141816 | 436424.382246523 | 445152.869891454 | 454055.927289283 |
Additional Space | 135252 | 275914.08 | 422148.5424 | 574122.017664 | 732005.5725216 | 895974.820766438 | 1066210.03671206 | 1242896.2713672 | 1426223.47139387 | 1616386.60091305 | 1813585.76622444 | 2018026.34350792 | 2229919.10957625 | 2449480.37574992 | 1950000 |
Total | 1468252 | 1608914.08 | 1755148.5424 | 3887796.017664 | 4111953.0525216 | 4343521.25036644 | 4582707.39490406 | 4829723.57672304 | 5084787.32285682 | 5348121.72940527 | 5619955.5972865 | 5900523.57119122 | 6190066.28181322 | 6488830.49143162 | 6070137.11799534 |
Option-2 | |||||||||||||||
Buy Class A | 19600560 | 8223571.2 | 1197042.624 | 1220983.47648 | 1245403.1460096 | 1270311.20892979 | 1295717.43310839 | 1321631.78177056 | 1348064.41740597 | 1375025.70575409 | 1402526.21986917 | 1430576.74426655 | 1459188.27915188 | 1488372.04473492 | 1518139.48562962 |
Rent from retail | -281280 | -281280 | -281280 | -609440 | -609440 | -609440 | -609440 | -609440 | -609440 | -609440 | -609440 | -609440 | -609440 | -609440 | -609440 |
Class C office | 243000 | 243000 | 243000 | 358020 | 365180.4 | 372484.008 | 379933.68816 | 387532.3619232 | 395283.009161664 | 403188.669344897 | 411252.442731795 | 419477.491586431 | 427867.04141816 | 436424.382246523 | 445152.87 |
Additional Space | 132600 | 270504 | 413871.12 | 562864.7232 | 717652.52208 | 878406.68702592 | 1045303.95756084 | 1218525.75624236 | 1398258.3052881 | 1584692.74599318 | 1778025.26100435 | 1978457.19951757 | 2186195.20546692 | 2401451.34877443 | 2401451.34877443 |
Depreciation tax saving | 236600 | 334600 | 432600 | 432600 | 432600 | 432600 | 432600 | 432600 | 432600 | 432600 | 432600 | 432600 | 432600 | 432600 | 334600 |
Terminal Value | 100220743.420653 | ||||||||||||||
Total | 19458280 | 8121195.2 | 1140033.744 | 1099828.19968 | 1286196.0680896 | 1479161.90395571 | 1678915.07882923 | 1885649.89993611 | 2099565.73185573 | 2320867.12109217 | 2549763.92360532 | 2786471.43537055 | 3031210.52603696 | -9045792.22424413 | -96800039.7163578 |
Option-3 | |||||||||||||||
Build a high raiser | 100000 | 4500000 | 22000000 | 22000000 | |||||||||||
Class A office | 1090000 | 1090000 | 1090000 | ||||||||||||
Class C office | 243000 | 243000 | 243000 | ||||||||||||
Additional Space | 132600 | 270504 | 413871.12 | ||||||||||||
OPEX | 8895000 | 9254358 | 9439445.16 | 9628234.0632 | 9820798.744464 | 10017214.7193533 | 10217559.0137403 | 10421910.1940152 | 10630348.3978955 | 10842955.3658534 | 11059814.4731704 | 11281010.7626338 | 11506630.9778865 | 11736763.5974442 | 11971498.8693931 |
Rent from retail | -1163250 | ||||||||||||||
Depreciation tax saving | 192500 | 192500 | 192500 | 192500 | 192500 | 192500 | 192500 | 192500 | 192500 | 192500 | 192500 | ||||
Terminal Value | 1115477074.86594 | ||||||||||||||
Net Cash outflow | 8995000 | 15219958 | 33042949.16 | 33375105.1832 | 8465048.744464 | 9824714.71935328 | 10025059.0137403 | 10229410.1940152 | 10437848.3978955 | 10650455.3658534 | 10867314.4731704 | 11088510.7626338 | 11314130.9778865 | 11544263.5974442 | -1103698075.99655 |
Year | Option 1 | PV | Option 2 | option 3 | |||
1 | 2000 | 1468252 | 1,325,354.48 | 19458280 | $17,564,504.27 | 8995000 | $8,119,562.26 |
2 | 2001 | 1608914.08 | 1,310,979.04 | 8121195.2 | $6,617,330.82 | 15219958 | $12,401,560.93 |
3 | 2002 | 1755148.5424 | 1,290,946.44 | 1238033.744 | $910,598.28 | 33042949.16 | $24,303,742.10 |
4 | 2003 | $3,887,796.02 | 2,581,245.22 | $1,197,828.20 | $795,280.49 | $33,375,105.18 | $22,158,912.25 |
5 | 2004 | 4111953.0525216 | 2,464,367.04 | 1384196.0680896 | $829,573.47 | 8465048.744464 | $5,073,255.17 |
6 | 2005 | $4,343,521.25 | 2,349,798.61 | $1,577,161.90 | $853,227.75 | $9,824,714.72 | $5,315,065.74 |
7 | 2006 | 4582707.39490406 | 2,237,908.21 | 1776915.07882923 | $867,734.40 | 10025059.0137403 | $4,895,612.99 |
8 | 2007 | 4829723.57672304 | 2,128,991.19 | 1983649.89993611 | $874,413.02 | 10229410.1940152 | $4,509,227.88 |
9 | 2008 | 5084787.32285682 | 2,023,279.26 | 2197565.73185573 | $874,429.72 | 10437848.3978955 | $4,153,306.89 |
10 | 2009 | 5348121.72940526 | 1,920,948.71 | 2418867.12109217 | $868,813.37 | 10650455.3658534 | $3,825,451.17 |
11 | 2010 | 5619955.5972865 | 1,822,127.74 | 2647763.92360532 | $858,470.14 | 10867314.4731704 | $3,523,450.46 |
12 | 2011 | 5900523.57119122 | 1,726,902.96 | 2884471.43537055 | $844,196.65 | 11088510.7626338 | $3,245,268.29 |
13 | 2012 | 6190066.28181322 | 1,635,325.21 | 3129210.52603696 | $826,691.77 | 11314130.9778865 | $2,989,028.35 |
14 | 2013 | 6488830.49143162 | 1,547,414.67 | -9045792.22424413 | $-2,157,182.50 | 11544263.5974442 | $2,753,001.93 |
15 | 2014 | 6070137.11799534 | 1,306,682.97 | -96800039.7163578 | $-20,837,579.28 | -1103698075.99655 | $-237,586,639.69 |
27,672,271.75 | 10,590,502.38 | -130,320,193.28 |
Pv Factor | Increment 1to 2 | PV | Increment 1 to 3 | PV |
0.90 | -17,990,028.00 | -16,239,149.80 | -7,526,748.00 | -6,794,207.78 |
0.81 | -6,512,281.12 | -5,306,351.77 | -13,611,043.92 | -11,090,581.88 |
0.74 | 517,114.80 | 380,348.15 | -31,287,800.62 | -23,012,795.67 |
0.66 | 2,689,967.82 | 1,785,964.73 | -29,487,309.17 | -19,577,667.03 |
0.60 | 2,727,756.98 | 1,634,793.57 | -4,353,095.69 | -2,608,888.13 |
0.54 | 2,766,359.35 | 1,496,570.86 | -5,481,193.47 | -2,965,267.13 |
0.49 | 2,805,792.32 | 1,370,173.81 | -5,442,351.62 | -2,657,704.78 |
0.44 | 2,846,073.68 | 1,254,578.17 | -5,399,686.62 | -2,380,236.69 |
0.40 | 2,887,221.59 | 1,148,849.54 | -5,353,061.08 | -2,130,027.63 |
0.36 | 2,929,254.61 | 1,052,135.34 | -5,302,333.64 | -1,904,502.46 |
0.32 | 2,972,191.67 | 963,657.59 | -5,247,358.88 | -1,701,322.72 |
0.29 | 3,016,052.14 | 882,706.30 | -5,187,987.19 | -1,518,365.33 |
0.26 | 3,060,855.76 | 808,633.44 | -5,124,064.70 | -1,353,703.14 |
0.24 | 15,534,622.72 | 3,704,597.17 | -5,055,433.11 | -1,205,587.26 |
0.22 | 102,870,176.83 | -5062492.87768419 | 1,109,768,213.11 | -80900857.6274779 |
-10,124,985.76 | -161,801,715.25 |
WACC | |
Beta for REIT | 0.8 |
Debt to equity ratio for Reit | 1 |
Debt of First national | 8.1 billion |
Equity of First National | 18 |
Debt Equity ratio of FN | 0.45 |
Beta For FN | 1.034 |
Rf | 6.50% |
Rm | 8.40% |
Cost of equity | 15.185600% |
Cost of debt | 6.56% |
WACC | 10.78% |
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