Chapter 17 Does Debt Policy Matter? 459
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QUESTIONS
Suppose the present value of the building equals its purchase price of $10 million. Assume that
the law firm can finance the offices in London and Brussels from operating cash flow, with cash
left over for the lease payments. The firm will not default on the lease payments. For simplicity
you can ignore taxes.
- If the law firm takes the lease, it will invest $950,000 and in effect borrow $9,050,000, repaid
by 19 installments of $950,000. What is the interest rate on this disguised loan? - The law firm could finance 80% of the purchase price with a conventional mortgage at a 7%
interest rate. Is the conventional mortgage better than the lease? - Construct a simple numerical example to convince Drywall that the lease would expose the
law firm to financial risk. Hint: What is the rate of return on the firm’s equity investment in
the office building if a recession arrives and the market value of the (leased) office build-
ing falls to $9 million after one year? What is the rate of return with conventional mortgage
financing? With all-equity financing? - Do the investments in London and Brussels have anything to do with the decision to finance
the office building? Explain briefly.