Deck 19: Investment Decisions: Npv and Irr

Question 1

A real estate investment is available at an initial cash outlay of $10,000 and is expected to yield cash flows of $3,343.81 per year for five years. The internal rate of return is approximately:

A) 2 percent.
B) 20 percent.
C) 23 percent.
D) 17 percent.

Answer 1

IRR (Internal Rate of Return) of project is the rate at which the NPV (Net Present Value) of project becomes zero.. It is simple to apply. The project which has IRR greater than its required rate of return should be accepted.
The IRR can be computed using the "IRR" function of spreadsheet
Compute the "IRR" using the spreadsheet. Enter given values and formula in the spreadsheet as shown in the image below.
Obtained result is provided below.
Thus, the internal rate of return is
.
Therefore, the correct answer is
.

Question 2

What is the IRR, assuming an industrial building can be purchased for $250,000 and is expected to yield cash flows of $18,000 for each of the next five years and be sold at the end of the fifth year for $280,000

A) 0.09 percent
B) 4.57 percent
C) 9.20 percent
D) 10.37 percent

Answer 2

Internal rate of return (IRR) of a project is the rate at which the present value of future cash flows equals to the initial investment. It is a method used to calculate the discount rate at which present value of future cash flows and initial investment is equal.
IRR is calculated by using formula:
Here,
CF - Future cash flows
IRR - Internal Rate of Return
n - Expected life of project
The IRR is evaluated by calculating the NPV of the Project at different levels of discount rate. The rate, at which NPV is 0, is the IRR of the project.
NPV is the difference between present value future of cash flows and initial investment. It is a technique which considers time value of money in evaluating capital investments.
NPV is calculated as:
Calculation of IRR of the project:
Initial outlay - $250,000
Free cash flow - $18,000
n - 05 years
The IRR is evaluated by calculating the NPV of the Project at different levels of discount rate. The rate at which NPV is 0 is the IRR of the project.
IRR of the project:
From the above table it is clear that IRR is between 9% and 10%. To find the exact rate of IRR can be obtained by using formula:
Formulas:
Calculate the IRR by using the following formula:
Where:
LR - Lower Rate
HR- Higher Rate
IRR:
Therefore, the IRR of the project is
.
Therefore,
is correct.

Question 3

Why might a commercial real estate investor borrow to help finance an investment even if she could afford to pay 100 percent cash

Answer 3

Borrowing--i.e., the use of "other people's money"-is also refereed to as the use of financial leverage. If the overall return on the property exceeds the cost of debt, the use of leverage can significantly increase the rate of return investors earn on their invested equity. This expected magnification of return often induces investors to partially debt finance even if they have the accumulated wealth to pay all cash for the property. Other potential benefits of leverage include: the ability to break through equity capital constraint in order to acquire more + NPV projects; the ability to apply the owner/operator's comparative advantage in acquisition and management to more projects; and increased portfolio diversification.

Question 4

You are considering the purchase of an apartment complex. The following assumptions are made:
• The purchase price is $1 million.
• Potential gross income ( PGI ) for the first year of operations is projected to be $171,000.
• PGI is expected to increase 4 percent per year.
• No vacancies are expected.
• Operating expenses are estimated at 35 percent of effective gross income. Ignore capital expenditures.
• The market value of the investment is expected to increase 4 percent per year.
• Selling expenses will be 4 percent.
• The holding period is four years.
• The appropriate unlevered rate of return to discount projected NOI s and the projected NSP is 12 percent.
• The required levered rate of return is 14 percent.
• 70 percent of the acquisition price can be borrowed with a 30-year, monthly payment mortgage.
• The annual interest rate on the mortgage will be 8 percent.
• Financing costs will equal 2 percent of the loan amount.
• There are no prepayment penalties.
a. Calculate net operating income ( NOI ) for each of the four years.
b. Calculate the net sale proceeds from the sale of the property.
c. Calculate the net present value of this investment, assuming no mortgage debt. Should you purchase Why
d. Calculate the internal rate of return of this investment, assuming no debt. Should you purchase Why
e. Calculate the monthly mortgage payment. What is the total per year
f. Calculate the loan balance at the end of years 1, 2, 3, and 4. ( Note: The unpaid mortgage balance at any time is equal to the present value of the remaining payments, discounted at the contract rate of interest).
g. Calculate the amount of principal reduction achieved during each of the four years.
h. Calculate the total interest paid during each of the four years. (Remember: Debt service = Principal + Interest.)
i. Calculate the (levered) required initial equity investment.
j. Calculate the before-tax cash flow ( BTCF ) for each of the four years.
k. Calculate the before-tax equity reversion ( BTER ) from the sale of the property.
l. Calculate the (levered) net present value of this investment. Should you purchase Why
m. Calculate the (levered) internal rate of return of this investment. Should you purchase Why
n. Calculate, for the first year of operations, the
(1) Overall (cap) rate of return.
(2) Equity dividend rate.
(3) Gross income multiplier.
(4) Debt coverage ratio.

Question 5

The net present value of an acquisition is equal to:

A) The present value of expected future cash flows, plus the initial cash outlay.
B) The present value of expected future cash flows, less the initial cash outlay.
C) The sum of expected future cash flows, less the initial cash outlay.
D) None of the above.

Question 6

Which of the following is the least true

A) Levered discount rates are greater than unlevered discount rates.
B) Levered, before-tax discount rates are greater than unlevered, before-tax discount rates.
C) After-tax discount rates are less than discount rates used to value before-tax cash flows.
D) After-tax discount rates are greater than discount rates used to value before-tax cash flows.

Question 7

Using the CFj key of your financial calculator, determine the IRR of the following series of annual cash flows: CF 0 = - $31,400; CF 1 = $3,292; CF 2 = $3,567; CF 3 = $3,850; CF 4 = $4,141; and CF 5 = $50,659.

Question 8

The expected before-tax IRR on a potential real estate investment is 14 percent. The expected after-tax IRR is 10.5 percent. What is the effective tax rate on this investment

Question 9

Present value:

A) In excess of zero means a project is expected to yield a rate of return in excess of the discount rate employed.
B) Is the value now of all net benefits that are expected to be received in the future.
C) Will always equal zero when the discount rate is the internal rate of return.
D) Will always equal a project's purchase price when the discount rate is the internal rate of return.

Question 10

An office building is purchased with the following projected cash flows:
• NOI is expected to be $130,000 in year 1 with 5 percent annual increases.
• The purchase price of the property is $720,000.
• 100 percent equity financing is used to purchase the property.
• The property is sold at the end of year 4 for $860,000 with selling costs of 4 percent.
• The required unlevered rate of return is 14 percent.
a. Calculate the unlevered internal rate of return ( IRR ).
b. Calculate the unlevered net present value ( NPV ).

Question 11

A retail shopping center is purchased for $2.1 million. During the next four years, the property appreciates at 4 percent per year. At the time of purchase, the property is financed with a 75 percent loan-to-value ratio for 30 years at 8 percent (annual) with monthly amortization. At the end of year 4, the property is sold with 8 percent selling expenses. What is the before-tax equity reversion

Question 12

The internal rate of return equation incorporates:

A) Future cash outflows and inflows, but not initial cash flows.
B) Future cash outflows and inflows, and initial cash outflow, but not initial cash inflow.
C) Initial cash outflow and inflow, and future cash inflows, but not future cash outflows.
D) Initial cash outflow and inflow, and future cash outflow and inflow.

Question 13

State, in no more than one sentence, the condition for favorable financial leverage in the calculation of NPV.

Question 14

The purchase price that will yield an investor the lowest acceptable rate of return is:

A) The property's investment value to that investor.
B) The property's net present value.
C) The present value of anticipated future cash flows.
D) Computed using the risk-free discount rate.

Question 15

State, in no more than one sentence, the condition for favorable financial leverage in the calculation of the IRR.

Question 16

What term best describes the maximum price a buyer is willing to pay for a property

A) Investment value.
B) Highest and best use value.
C) Competitive value.
D) Market value.

Question 17

An office building is purchased with the following projected cash flows:
• NOI is expected to be $130,000 in year 1 with 5 percent annual increases.
• The purchase price of the property is $720,000.
• 100 percent equity financing is used to purchase the property.
• The property is sold at the end of year 4 for $860,000 with selling costs of 4 percent.
• The required unlevered rate of return is 14 percent.
a. Calculate the unlevered internal rate of return ( IRR ).
b. Calculate the unlevered net present value ( NPV ).

Question 18

An income-producing property is priced at $600,000 and is expected to generate the following after-tax cash flows: Year 1: $42,000; Year 2: $44,000; Year 3: $45,000; Year 4: $50,000; and Year 5: $650,000. Would an investor with a required after-tax rate of return of 15 percent be wise to invest at the current price

A) No,the NPV is -$548,867.
B) No,the NPV is -$148,867.
C) Yes, the NPV is $51,133.
D) Yes,the NPV is $451,133.

Question 19

With a purchase price of $350,000, a small warehouse provides for an initial before-tax cash flow of $30,000, which grows by 6 percent a year. If the before-tax equity reversion after four years equals $90,000, and an initial equity investment of $175,000 is required, what is the IRR on the project If the required going-in levered rate of return on the project is 10 percent, should the warehouse be purchased

Question 20

As a general rule, using financial leverage:

A) Decreases risk to the equity investor.
B) Increases risk to the equity investor.
C) Has no impact on risk to the equity investor.
D) May increase or decrease risk to the equity investor, depending on the income tax treatment of the interest expense and the equity investor's marginal income tax bracket.

Question 21

List three important ways in which DCF valuation models differ from direct capitalization models.

Question 22

You are considering the acquisition of small office building. The purchase price is $775,000. Seventy-five percent of the purchase price can be borrowed with a 30-year, 7.5 percent mortgage. Payments will be made annually. Up-front financing costs will total 3 percent of the loan amount. The expected before-tax cash flows from operations, assuming a five-year holding period, are as follows:
The before-tax cash flow from the sale of the property is expected to be $295,050. What is the net present value of this investment, assuming a 12 percent required rate of return on levered cash flows What is the levered internal rate of return