Reference no: EM132992232

A-Tech currently spends $150,000 a year leasing office space in Austin. Because lease payments are tax deductible at 20% corporate tax rate, the firm spends $120,000 per year (i.e., $150,000 x (1-0.2)) on an after-tax basis to lease the building. Assume that the lease is perpetual (i.e., the firm can continue to lease the building at $150,000 forever if it wants to). The firm has no debt and has an equity beta of 2. Assuming an expected market return of 7% and a risk-free rate of 2%, its CAPM-based cost of capital is 12%.

Suppose that A-Tech has the opportunity to buy its office space for $5 million. The firm can finance 100% of the purchase price with a mortgage. Because the office building is a risk-free asset, the mortgage rate is equal to the risk-free rate of 2%. Note also that the interest paid on the mortgage is tax-deductible. Assume that the mortgage is perpetual, that is, the firm would be paying 2% mortgage interest on a loan of $5 million indefinitely if it buys the building.

Problem 1: How does A-Tech determine whether to buy the building or continue to lease it?