Chapter 11, Problem 18P

### Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250

Chapter
Section

### Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250
Textbook Problem

# NPV AND IRR A store has 5 years remaining on its lease in a mall. Rent is $2,000 per month, 60 payments remain, and the next payment is due in 1 month. The mall’s owner plans to sell the property in a year and wants rent at that time to be high so that the property will appear more valuable. Therefore, the store has been offered a “great deal” (owner’s words) on a new 5-year lease. The new lease calls for no rent for 9 months, then payments of$2,600 per month for the next 51 months. The lease cannot be broken, and the store’s WACC is 12% (or 1% per month). a. Should the new lease be accepted? (Hint Make sure you use 1% per month.) b. If the store owner decided to bargain with the mall’s owner over the new lease payment, what new lease payment would make the store owner indifferent between the new and old leases? (Hint: Find FV of the old lease’s original cost at t = 9; then treat this as the PV of a 51-period annuity whose payments represent the rent during months 10 to 60.) c. The store owner is not sure of the 12% WACC—it could be higher or lower. At what nominal WACC would the store owner be indifferent between the two leases? (Hint: Calculate the differences between the two payment streams; then find its IRR.)

a.

Summary Introduction

To explain: Whether the new lease plan should be accepted or not.

Introduction:

Net Present Value (NPV):

It is a method under capital budgeting which includes the computation of the net present value of the project in which company is investing. The calculation is done by calculating the difference between the value of cash inflow and value of cash outflow after taking into consideration the discounted rate.

Internal Rate of Return (IRR):

It refers to the rate of return that is computed by the company to make a decision of selection of a project for investment. This rate provides the basis for selection of projects with a lower cost of capital and rejection of project with a higher cost of capital.

Explanation

Given information:

Life of the new and old lease plan is 5 years.

Cash inflow per month for old lease plan is $2,000. Cash inflow per month for new lease plan is$0 for first 9 months and $2,600 for rest 51 months. The cost of capital is 12%. The calculation of NPV for old lease plan on a spreadsheet, Table (1) The NPV of old lease plan is$86514.62.

The calculation of NPV for new lease plan on a spreadsheet,

b.

Summary Introduction

To determine: The new lease payment so that the owner will get indifferent between the new and the old lease plan.

c.

Summary Introduction

To calculate: The nominal WACC so that the owner would be indifferent between the two plans.

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