Kania School of Management, University of Scranton, Scranton, PA 18510
Schott Technologies is a high-tech firm located in Duryea, Pennsylvania. It specializes in the manufacture of various types of optical glass. It has its head office at Mainz, Germany. Several of the scientists and engineers working in Duryea originally came from Germany. Frequently a person from Germany has a short-term assignment in Pennsylvania lasting no more than a year. In fall 1990, Joseph Hankel, the personnel manager at Schott was considering the possibility of buying an apartment at Forum Plaza to accommodate the short-term visitors.
Forum Plaza is an attractive nine-story building with ten apartments on each floor. Located in downtown Scranton, it is close to stores and offices. The management of the apartments is in the form of a condominium. There are three apartment sizes: one-bedroom (702 sq ft), two-bedroom (965 sq ft) and two- bedroom deluxe (1062 sq ft). Recent estimates for the construction cost for similar apartments have been around $125 a sq ft.
Hankel believes that the two-bedroom apartment is quite adequate for the use of the company, and Schott should buy such an apartment. His superior, Dr. Franz Stern, is not so sure about the advantages of buying the apartment and he prefers simply to lease the apartment on a yearly basis.
A one-year lease of the apartment requires a refundable security deposit of $750. The rent is $750, payable in advance each month. The tenants pay the utilities. The estimated bill for electricity is about $40 a month. The monthly gas bill for heat, hot water, and cooking is around $75. The utility bills are due at the end of every month.
The analysis of buying the apartment is more complicated. The offering price of the apartment is $120,000. The company can take a 30-year mortgage loan from the bank at 6% interest rate, for 80% of the value of the apartment. Schott will provide the remaining 20% of the purchase price of the apartment, through the regular borrowing of the company at 8.5% interest rate. The marginal income tax rate of Schott is 28%.
The bank charges $125 as mortgage application fee along with 1.5 points. The "points" represent a fee equal to 1.5% of the amount of mortgage loan. The attorney's fee is $325, and the deed recording fee is $50. The county tax office levies a transfer tax equal to 1.85% of the purchase price of the apartment. For Schott, these taxes and fees are tax deductible.
If Schott buys the apartment then it has to pay condominium fee, $170 a month, in advance each month. The condominium fee covers the following expenses: maintenance of the common areas, hallways, elevators, and the roof of the building. It also pays the water and sewer bills.
The real estate tax for the apartment is $1600 a year, payable in advance each year. The hazard insurance on the apartment costs $600 a year, payable in advance annually. Schott must also pay for the utilities in this case.
Hankel thinks that he should compare the cost of buying or leasing over a three-year and a five-year period. He feels that on an annual basis the rents will rise by 5% and the real estate taxes by 4%. Further, Hankel believes that the condominium fee will increase by 4% annually in the near future.
The value of the apartment will appreciate depending upon the general development of downtown Scranton. The construction of a downtown shopping mall will have a favorable impact on the property values. There is a 30% chance that the construction of mall will be complete in three years and almost certainly after 5 years. Hankel estimated that the value of the apartment would rise by 3% annually before the completion of the mall and by 5% annually after its completion.
At the time of selling the apartment, after three or five years, Schott has to pay commission to a real estate agent. Although negotiable, this commission averages around 5% of the selling price of the apartment. Again, there is a 1.85% transfer tax calculated on the selling price. The company must also pay income tax on the profit (net selling price minus current book value) on the apartment. Schott will depreciate the apartment on a straight-line basis over a period of 27.5 years.
Schott pays income taxes at the end of each year. The company also realizes the tax benefits of rent payments and depreciation the end of the year.
Hankel had heard that a computer program that could analyze similar problems was available at University of Scranton. Some MBA students had developed the program using Maple.