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Marty's Department Stores, Ltd is considering the purchase of one of two large structures of similar layout and area in the middle of a commercial district in the city of Gotham. Marty’s intends to use the three-story structure to open a new retail outfit that it expects to generate a free cash flow of $6.30 million in year one. Marty’s also expects the growth rate of the cash flows to be 5% per year for the 25-year life of the project. The current price of the structure is $80 million. Marty’s managers estimate that the value of the structure will grow by 4% per year for the coming twenty five years. Assume Marty’s can depreciate the structure on a straight line basis for a book value of zero over a useful life of 40 years. The required rate of return on Marty’s investment in new store locations is 12%. Marty’s marginal tax rate is 40%.
1. Calculate the NPV of the proposed new store based on the estimates of Marty’s managers.
2. What mistake could Marty’s managers have made in their project evaluation in part (a) above?
3. One of the managers visited the identical structure next door and learned that the business operating it pays $16 million in rent per year, based on a 25-year contract. With that piece of information, she goes back to the drawing board to correct the possible mistake committed as per part b above. Calculate the new NPV that she should obtain for the project based on this last information.
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