Reference no: EM132771684

Question - Facts: Galena Furniture Works, Inc. (GFW) appreciated your assistance in preparing their 2019 Federal income tax return. As a result, they have come to you for advice on acquiring a new building that will provide additional warehouse space and space for their corporate offices. They plan to take access to their new facility on January 2, 2021.

GFW has the opportunity to purchase an appropriate facility outside Galena for $2,500,000 ($2,400,000 for the building; $100,000 for the land). If they purchase the facility, they would finance the acquisition via a 15-year mortgage at 3% interest with a $500,000 down payment (due at closing on January 2, 2021). The mortgage would be payable annually in arrears (i.e., the first mortgage payment would be due January 2, 2022). Real property taxes on the facility in 2021 would be $130,000 (the property taxes are also due annually in arrears with 2021 taxes due on January 2, 2022). Further, GFW estimates that property taxes will increase annually at a rate of 2% in years subsequent to 2021.

As an alternative, a local real estate investor has offered to purchase the facility and lease it to the corporation. The investor would require GFW to sign a 7-year non-cancelable lease. The first lease payment of $180,000 would be due on January 2, 2021. Lease payments will increase by 3% each year during the term of the lease with the final lease payment due on January 2, 2027. In addition, the lease would require a refundable deposit of $90,000 (payment due on January 2, 2021) against significant damages to the facility; this deposit will be refunded to GFW on January 2, 2028 (when the occupancy ends and assuming that there are no significant damages).

GFW must decide whether to lease or buy the facility. In order to account for the potential increase in value of the land and building that would be obtained if GFW purchases the facility, the corporation will assume that it could sell the facility (building and land) on January 2, 2028 for $3,000,000. Under this scenario, they would make their final mortgage and property tax payments on January 2, 2028 and then sell the facility.

GFW's Federal corporate tax rate is 21% and it uses an 8% discount rate to compute the present value of its future cash flows. For purposes of this analysis, assume that all cash flows occur at the beginning of the respective year.

Required -

1. Based on the above facts, which option (lease or buy) minimizes GFW's after-tax cost of obtaining the facility?

2. The local real estate investor has provided an option for GFW to consider. Under this option, a payment of $720,000 is due on January 2, 2021. If this payment is made, no deposit is required and the payment is deemed to cover the first four years of the lease. On January 2, 2025, lease payments resume with a $200,000 lease payment due (and a 4% increase in the lease payment each year for the remainder of the lease term). Is this an alternative that GFW should consider? Read and apply the materials in text Section 6- 2d as part of your analysis.

3. GFW's President is not certain that the current 21% Federal income tax rate for corporations will be maintained over the next seven years. She feels that an increase in the Federal income tax rate to around 30% is likely at some point in the near term. As a result, she would like to know how your analysis would be affected if the Federal income tax rate increased to 30% on January 1, 2026.

Support your conclusions with a comparison of the net present value of each option and a written response to Julia Evans, President of Galena Furniture Works, Inc. (one to two pages, typed, single-spaced).

The case requires you to submit two files to me via email:

(1) An Excel spreadsheet that summarizes your net present value calculations for the various options (along with any related calculations, appropriately using Excel functions), and

(2) A memorandum (Word) that summarizes your work and recommendations.