Assume there are two possible rent contracts:
Contract 1: Deposit US$150,000. No rent and get back US$150,000 after two years.
Contract 2: Deposit US$10,000. Rent of US$12,000 per year. Get back US$10,000 after two years.
If my discount factor is 1% then contact 1’s NPV > contract 2’s NPV. If my discount factor is 10% then the inverse would be true.
The solutions says that c.8.2% is the breakeven point where both contracts would be equal.
However, assume my discount factor was say 4%. Under the standard calculation, contract 1 would have the following cash flows:
T0: (150,000) T1: 0 T2: (150,000)/((1.04)^2)
This would give an NPV of (11,317).
Contract 2 would have the following cash flows:
T0: (10,000) T1: (12,000)/((1.04)^1) T2: (2000)/(1.04)^2
This gives an NPV of (23,387.57)
BUT
Contract 2 has the added advantage of me having to spend US$140,000 less at the outset. That US$140,000 has the advantage of giving me cash flows of US$5,600 (US$140,000(0.04))(1.04) in the first year (the first year figure would also earn that 4%) and US$5,600 (The amount earned in the second year).
Shouldn’t these cash flows also be added to contract 2 above thus making the solution (breakeven point of 8.2%) wrong?
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