Reference no: EM131750559

Question: In order to alleviate its somewhat strained cash position, Storerite Corporation considers signing a sale-and-leaseback arrangement with a finance company on one of its warehouses. Under the arrangement, Storerite would sell the warehouse for $ 1,000,000 and then lease it back over a 10-year term for annual lease payments of $127,000. Lease payments are due at the beginning of each year, with tax shields available at yearend. $400,000 of the $ 1,000,000 selling price is deemed to be the value of the building, and the remaining $600,000 is the value of the land. Capital cost allowances on the building are taken on a declining balance at a rate of 10 percent. At the end of 10 years, the building is likely to be worthless, but the land is expected to appreciate at the average inflation rate, which is anticipated to be 5 percent per year. An appropriate riskadjusted discount rate for the residual land value would be 12 percent. Storerite can float 1 0-year debt at an interest rate of 10 percent, and its tax rate is 50 percent.

(a) Is the lease financing attractive?

(b) How high would the average annual inflation rate have to be so that Storerite becomes indifferent between leasing and borrowing?