Warehouse Buy, Lease or Third-Party Logistics in an SEZ
Ravi Distribution must replace its Lahore warehouse. Option 1 is to buy a 60,000 sq ft facility in a Special Economic Zone for PKR 600 million, with annual maintenance of PKR 12 million and an expected sale value of PKR 450 million after 10 years. The SEZ grants a 10-year tax holiday, and tax depreciation is 10% reducing balance. Option 2 is to lease an equivalent facility at PKR 78 million a year for 10 years, including maintenance, with no renewal obligation. Option 3 is third-party logistics at PKR 95 million a year, fully variable. The company's WACC is 16%, its pre-tax borrowing rate is 12.5%, and the tax rate is 29%. The CFO intends to discount all three at 16% and to add the depreciation tax shield to the buy option. Working capital of PKR 40 million is required for buy and lease but not for third-party logistics. The board wants the lowest-cost option and a view on flexibility.
1. Which discount rate should be used for each option, and how does the 10-year tax holiday affect the depreciation shield and lease deductibility?
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Buy versus lease is a financing decision, so discount the contractual buy and lease cash flows at the after-tax borrowing rate: 12.5% x (1 - 0.29) = 8.9%. Third-party logistics is an operating decision with variable volume risk, so its cash flows belong at the 16% WACC, or at a rate reflecting that operating risk. Comparing all three at 16% is not wrong for a rough screening, but it understates the financing advantage of the lease and overstates the certainty of the third-party fee.
The 10-year tax holiday removes both tax shields for the whole comparison period. The buy option generates no depreciation tax shield because there is no taxable income to shield. The lease payments are not deductible either, because the holiday applies to the SEZ business. The CFO's plan to add the depreciation shield is therefore wrong unless the company has taxable income elsewhere that the SEZ losses can offset, which is unlikely if the holiday is ring-fenced. With no shields, the comparison is essentially pre-tax cash cost, adjusted for working capital and terminal value.
2. Compute the present cost of each option and recommend one, stating assumptions about terminal value and working capital.
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At 8.9%, the 10-year annuity factor is 6.453 and the year-10 discount factor is 0.426.
Buy: capex 600 + maintenance 12 x 6.453 = 77.4 + working capital 40 - recovery 40 x 0.426 = 17.0, minus terminal value 450 x 0.426 = 191.6. Net present cost = 600 + 77.4 + 23.0 - 191.6 = PKR 508.8m.
Lease: 78 x 6.453 = 503.3 + working capital net 23.0 = PKR 526.3m. No terminal value.
Third-party: 95 x 6.453 = PKR 613.0m at 8.9%; at 16% the factor is 4.833, giving PKR 459.1m, but that is not directly comparable because the fee is variable.
On the financing comparison, buy is slightly cheaper than lease by about PKR 17.5m, and both are cheaper than third-party at a comparable discount rate. Recommend buy if the company is confident about volume and the terminal value; lease is close enough that flexibility and balance-sheet treatment may decide it. The terminal value assumes a functioning industrial property market and no tax on sale; if the sale is taxed, add the tax to the buy cost.
3. Suppose the SEZ holiday is five years and the company expects taxable profits from year 6. How does the ranking change, and what value would you place on lease flexibility?
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With a five-year holiday, the buy option gets depreciation shields only in years 6-10. Depreciation is 60, 54, 48.6, 43.7 and 39.4 in years 1-5, then 35.4, 31.9, 28.7, 25.8 and 23.2 in years 6-10. The tax shields in years 6-10 are 10.3, 9.3, 8.3, 7.5 and 6.7, with a PV at 8.9% of about PKR 21.8m. Buy net cost falls to about PKR 487.0m.
The lease gets deductions of 78 x 29% = PKR 22.6m in years 6-10, with a PV of about PKR 57.6m. Lease net cost falls to about PKR 468.7m. Lease now beats buy by about PKR 18m. Third-party gets deductions of 95 x 29% = PKR 27.6m in years 6-10, a PV of about PKR 70.1m, but remains more expensive at about PKR 542.9m.
Lease flexibility is worth the small premium when volume is uncertain. The lease avoids a PKR 600m capital commitment and a terminal-value bet, and it can be exited after 10 years. Third-party logistics is the most flexible but costs roughly PKR 74m more in present value than lease; that premium is only justified if demand can fall by enough to make the variable cost structure cheaper.