Instead of paying $10,000 in annual rent for an office space for the next 10 yea

Question

Instead of paying $10,000 in annual rent for an office space for the next 10 years, an engineering consulting firm that you work for decides to take out a $100,000 loan at 6% interest for the same 10 year period. The firm will invest the $10,000 saved in rent each year into an account that earns 18% (growth stocks). Choose the result of the analysis that you will convey to the firm. Does this make financial sense?

a. Need $3300/year more, NO

b. Break even

c. Bonus $1600/year, YES

d. Need $1800/year more, NO

e. none of these

Explanation / Answer

d. Need $1800/year more

We need to calculate the annual payment that has to be done on the loan of 100,000. This can done by using excel PMT function

In the PMT function use the following inputs: rate = 6%, nper = 10 , PV = 100000

This will give us the

Annual Payment = 13586.7958

Alternatively we can solve the following lenghty equation to get payment (Y)

100000 = Y/(1.06)^1 + Y/(1.06)^2 + Y/(1.06)^3 + ....... + Y/(1.06)^10

This will give us the same value of Y = 13586.7958

Further, we are saving 10,000 on rent which gives us a return of 18% so this will amount a total payment of 10,000 x (1+18%) = 11800

The savings and earning of 18% on that saving is not sufficient to cover the yearly payment in the first year itself

Shortfall Amount = 13586 - 11800 = 1787/Year (approximately 1800/ Year)

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