Question 5.4: Patel Properties Ltd has the opportunity to acquire a lease ...
Patel Properties Ltd has the opportunity to acquire a lease on a block of flats that has only two years remaining before it expires. The cost of the lease would be £1,000,000. The occupancy rate of the block of flats is currently around 70 per cent and the flats are let almost exclusively to naval personnel. There is a large naval base located nearby and there is little other demand for the flats. The occupancy rate of the flats will change in the remaining two years of the lease depending on the outcome of a defence review.
The navy is considering three options for the naval base:
- Option 1. Increase the size of the base by closing down a naval base in another region and transferring the naval personnel to the base located near to the flats.
- Option 2. Close down the naval base near to the flats and leave only a skeleton staff there for maintenance purposes. The personnel would be moved to a base in another region.
- Option 3. Leave the naval base open but reduce staffing levels by 20 per cent.
The directors of Patel Properties Ltd have estimated the following net cash flows for each of the two years under each option and the probability of their occurrence:
| £ | Probability | |
| Option 1 | 800,000 | 0.6 |
| Option 2 | 120,000 | 0.1 |
| Option 3 | 400,000 | \underline{0.3} |
| \underline{1.0} |
Note: The sum of the probabilities is 1.0 (that is, it is certain that one of the possible options will arise).
The business has a cost of capital of 10 per cent.
Should the business purchase the lease on the block of flats?
To answer the question, the ENPV of the proposed investment can be calculated. To do this, the weighted average of the possible outcomes for each year must first be calculated. This involves multiplying each cash flow by its probability of occurrence (as the probabilities are used as weights). The expected annual net cash flows will be:
| Cash flows (a) | Probability (b) | Expected cash flows (a × b) | |
| £ | £ | ||
| Option 1 | 800,000 | 0.6 | 480,000 |
| Option 2 | 120,000 | 0.1 | 12,000 |
| Option 3 | 400,000 | 0.3 | \underline{120,000} |
| Expected net cash flows in each year | \underline{612,000} | ||
Having derived the expected net cash flows in each year, they can be discounted using a rate of 10 per cent to reflect the cost of capital.
| Expected cash flows |
Discount rate 10% |
Expected present value |
|
| £ | £ | ||
| Year 1 | 612,000 | 0.909 | 556,308 |
| Year 2 | 612,000 | 0.826 | \underline{505,512} |
| 1,061,820 | |||
| Less Initial investment | \underline{(1,000,000)} | ||
| Expected net present value (ENPV) | \underline{61,820} | ||
We can see that the ENPV is positive. Hence, the wealth of shareholders is expected to increase by purchasing the lease. (However, the size of the ENPV is small in relation to the initial investment and so the business may wish to check carefully the key assumptions used in the analysis before a final decision is made.)