Cost Management: A Strategic Emphasis 5th Edition by David Stout, Edward Blocher, Gary Cokins

Exercise 65

Capital Budgeting with Sensitivity Analysis Meidi Johnson has owned a medical professional building for the last 20 years. She leased the land from an adjacent medical school 22 years ago for 30 years and had the building constructed. At the end of the lease period, the medical school becomes the sole owner of the land, its improvements, and any structures on the land. The construction took two years. The building is in excellent condition and fully occupied at favorable rental rates. The value of the property has appreciated considerably. Because depreciation is based on the original construction cost, Meidi’s taxable income is unusually large.

George Kardell, a commercial real estate broker, has approached Meidi with a proposal from a group of investors. He believes that Meidi can sell the building and the balance of the leasehold at a price that will be profitable to all parties. The sale, if made, would be a cash sale that will provide her with the cash she needs for another project. She is currently negotiating with a bank for financing of this other project she is considering. The bank is asking for 12 percent interest.

Meidi, however, would use 10 percent as her cost of capital if she can sell the building for cash. The potential investor group’s cost of capital is 12 percent.

The buyer is in the 30 percent tax bracket. Meidi believes that she has been paying a marginal income tax rate of 40 percent in the last five years, and she expects no change in the next eight years. Unfortunately for her, the tax law in effect since last year eliminates any special tax rate for capital gains earned. This condensed income statement is taken from Meidi’s latest tax return.

Income Statement for 2010
Rental revenue		$2,000,000
Expenses
Operations	$950,000
Administration	70,000
Property taxes	280,000
Depreciation (straight line)	100,000	1,400,000
Net income before taxes		$ 600,000
Income taxes at 40 percent		240,000
Net income aftertaxes		$ 360,000

The buyer will use the straight-line depreciation method. No change in either rental revenue or expenses is expected.

Required

1. What is the maximum the buyer should pay? (Show details.)

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2. What is the minimum selling price Meidi can accept if she has to pay George a 5 percent commission? Assume that Meidi would want to be compensated for the lost rental incomes, plus any capital gains tax she’d have to pay in conjunction with the sale, plus the sales commission paid to the broker.

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3. What is the maximum the buyer would be willing to pay if the purchase is for a MACRS five-year property? Use the half-year convention.

Step 1 of 3

Capital Budgeting with Sensitivity Analysis(45-50 minutes)

1.

Expected annual net cash inflows ($600,000 + $100,000)	=	$700,000
Income tax at 30%	=	210,000
After-tax net cash inflows	=	$490,000

?The buyer is essentially purchasing an eight-year stream of after-tax rental incomes and income-tax savings associated with the depreciation deduction. Thus, a rational purchase price would be the PV of these future cash flows, using 12% as the discount rate. Note, however, that the depreciation deduction is a function of the purchase price, which we are trying to estimate. Therefore, let P denote the maximum price the buyer would be willing to pay. The amount is approximately $3 million, as follows: 

P	=	[$490,000 x A.12, 8] + [(P/8 x 0.3) x A.12, 8]
P	=	[$490,000 x 4.968] + [P/8 x 0.3 x 4.968]
P	=	$2,434,320 + 0.1863P
0.8137P	=	$2,434,320
P	=	$2,991,668