Case Problem 6

Claxton Drywall Comes to the Rescue

A law firm (not Dewey, Cheatem, and Howe) is expanding rapidly and must move to new office space. Business is good, and the firm is encouraged to purchase an entire building for $10 million. The building offers first-class office space, is conveniently located near their most important corporate clients, and provides space for future expansion. The firm is considering how to pay for it.

Claxton Drywall, a consultant, encourages the firm not to buy the building but to sign a long-term lease for the building instead. With lease financing, youll save $10 million. You wont have to put up any equity investment, Drywall explains.

The senior law partner asks about the terms of the lease. Ive taken the liberty to check, Drywall says. The lease will provide 100% financing. It will commit you to 20 fixed annual payments of $950,000, with the first payment due immediately.

The initial payment of $950,000 sounds like a down payment to me, the senior partner observes sourly

Good point, Drywall says amiably, but youll still save $9,050,000 up front. You can earn a handsome rate of return on that money. For example, I understand you are considering branch offices in London and Brussels. The $9 million would pay the costs of setting up the new offices, and the cash flows from the new offices should more than cover the lease payments. And theres no financial riskthe cash flows from the expansion will cover the lease payments with a safety cushion. Theres no reason for you or your partners to worry or to demand a higher-than-normal rate of return.

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?