The ABC Corporation is considering opening an office in a new market area that would allow it to increase its annual sales by $2.6 million. The cost of goods sold is estimated to be 40 percent of sales, and corporate overhead would increase by $306,000, not including the cost of either acquiring or leasing office space. The corporation will have to invest $2.6 million in office furniture, office equipment, and other up-front costs associated with opening the new office before considering the costs of owning or leasing the office space.
Problem 15-1
The ABC Corporation is considering opening an office in a new market area that would allow it to increase its annual sales by $2.6 million. The cost of goods sold is estimated to be 40 percent of sales, and corporate overhead would increase by $306,000, not including the cost of either acquiring or leasing office space. The corporation will have to invest $2.6 million in office furniture, office equipment, and other up-front costs associated with opening the new office before considering the costs of owning or leasing the office space.
A small office building could be purchased for sole use by the corporation at a total price of $5.7 million, of which $900,000 of the purchase price would represent land value, and $4.8 million would represent building value. The cost of the building would be
Required:
a. What is the return from opening the office building under the assumption that it is leased?
b. What is the return from opening the office building under the assumption that it is owned?
c. What is the return on the incremental cash flow from owning versus leasing
The internal rate of return or IRR is the sum of all inflows and outflows that becomes zero during the initial year. It is a capital budgeting technique which evaluates whether a project is worth taking or not. Therefore, it helps in the decision making of the company. If this return is higher than the company's required rate of return then the project is accepted otherwise the project is rejected.
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