Deck 19: Investment Decisions: NPV and IRR

Question 1

In discounted cash flow (DCF) analysis, the sale price of the property must be estimated at the end of the expected holding period. The most common method for determining the terminal value of the property is the:

A) yield capitalization method
B) direct capitalization method
C) repeat-sales approach
D) cost approach

Answer 1

B

Question 2

While the general concepts of investment value and market value are very similar, there is an important distinction between the two. All of the following statements regarding investment value are true EXCEPT:

A) Investment value is based on the expectations of a typical, or average, investor.
B) Investment value is a function of estimated cash flows from annual operations
C) Investment value takes into consideration estimated proceeds from the sale of the property
D) Investment value applies a discount rate to future cash flows.

Answer 2

A

Question 3

Many investors use mortgage debt to help finance capital investment for income-producing real estate. In doing so, the owner will receive income as long as the property produces enough income to cover all operating and capital expenditures, the mortgage payment, and all state and federal income taxes. Therefore, the owner's claim is commonly referred to as a:

A) primary claim
B) joint claim
C) residual claim
D) superior claim

Answer 3

C

Question 4

Net present value (NPV) is interpreted using the following decision rule: The investor will purchase the property as long as the NPV is:

A) greater than zero
B) equal to zero
C) less than zero
D) equal to the opportunity cost of investment

Question 5

Given the following information, calculate the estimated terminal value of the property at the end of its holding period. Going-out cap rate: 9%, Estimated holding period: 5 years, NOI for year 5: $100,500, NOI for year 6: $102,000.

A) $1,113,333
B) $1,116,667
C) $1,133,333
D) $1,166,667

Question 6

Just as it is important for an investor to consider the impact of financial leverage on her return, it is also necessary to account for the effect of income taxes. How would the presence of income taxes impact the levered going-in IRR?

A) Income taxes increase the levered going-in-IRR
B) Income taxes reduce the levered going-in-IRR
C) Income taxes do not affect the going-in-IRR
D) Income taxes cause the levered going-in-IRR to become invalid as a measure of return.

Question 7

Given the following information, calculate the before-tax equity reversion (BTER). NOI: $89,100, Annual Debt Service: $58,444, Net Sale Proceeds: $974,700, Remaining Mortgage Balance: $631,026.

A) $30,656
B) $343,674
C) $572,582
D) $885,600

Question 8

An important piece of criteria for investors to consider when deciding between real estate investment opportunities and investing in stocks or bonds is the effect of income taxes on their return. For most investors, the effective tax rate on commercial real estate is:

A) greater than the effective tax rate on a stock or bond investment
B) equal to the effective tax rate on a stock or bond investment
C) less than the effective tax rate on a stock or bond investment
D) cannot be compared across asset classes.

Question 9

Given the following information, calculate the appropriate after-tax discount rate. Tax rate on comparable risk investment: 35%, Investor's before-tax opportunity cost: 12%, Capitalization rate: 8%.

A) 2.8%
B) 4.2%
C) 5.2%
D) 7.8%

Question 10

Changes in the discount rate used to complete net present value analysis can have a significant impact on the estimated value of the investment and therefore affect the overall investment decision. As the required internal rate of return (IRR) increases, the net present value will:

A) decline
B) increase
C) remain the same
D) become zero

Question 11

In discounted cash flow analysis, the industry standard for pro forma cash flow projections of investment properties is typically:

A) 3 years
B) 5 years
C) 10 years
D) 15 years

Question 12

Given the following information, calculate the going-out cap rate. Estimated holding period: 5 years, NOI for year 1: $120,000, NOI for year 5: $150,000, NOI for year 6: $155,250, Expected sale price at end of year 5: $1,350,000.

A) 8.9%
B) 11.1%
C) 11.5%
D) 11.9%

Question 13

The use of financial leverage when investing in real estate is a double-edged sword. While increased leverage may allow the investor to "purchase" higher expected returns, the "price" of doing so is an increase in which of the following risks?

A) Liquidity risk
B) Default risk
C) Interest rate risk
D) Pipeline risk

Question 14

To overcome the potential shortcomings of single-year decision making metrics, many investors in real estate also perform multiyear discounted cash flow (DCF) valuation. DCF valuation differs from the single-year ratio analysis in all of the following ways EXCEPT:

A) Only with DCF must the investor estimate an appropriate investment horizon accounting for how long she will hold the property.
B) Only with DCF must the investor select the appropriate yield at which to discount all expected future cash flows.
C) Only with DCF must the investor make explicit forecasts of the property's net operating income for each year in the expected holding period.
D) Only with DCF must the investor use a defensible cash flow estimate that incorporates appropriate measures of income and expenses.

Question 15

It is common for investors in real estate to use mortgage debt to help finance capital investment. The use of debt can have a profound impact on the expected cash flows for a particular property. Which of the following terms refers to cash flows that represent the property's income after subtracting any payments due to the lender?

A) Levered cash flows
B) Unlevered cash flows
C) Discounted cash flows
D) Compounded cash flows

Question 16

While net present value (NPV) and internal rate of return (IRR) analysis both may be used as investment decision criteria, there are some limitations to the IRR method that make its use as an investment criterion problematic in certain situations. All of the following are limitations of the IRR method EXCEPT:

A) IRR calculations assume that cash flows are reinvested at the IRR, rather than at the actual rate that investors expected to earn on reinvested cash flows.
B) With the IRR decision criterion multiple solutions may exist for investments where the sign of the cash flows changes more than once over the expected holding period.
C) The IRR methodology cannot be used to make comparisons across different investment opportunities.
D) The use of IRR as a decision criterion will not necessarily result in wealth maximization for the investor.

Question 17

Given the following information, calculate the NPV for this property. Initial cash outflow: $200,000, Discount rate: 15%, CF for year 1: $25,876, CF for year 2: $23,998, CF for year 3: $23,013, CF for year 4: $22,105, CF for year 5: $144,670.

A) -$51,875
B) -$59,657
C) $140,343
D) $295,951

Question 18

The internal rate of return (IRR) on a proposed investment is the discount rate that makes the net present value of the investment:

A) greater than zero
B) equal to zero
C) less than zero
D) greater than the opportunity cost of not investing

Question 19

The use of financial leverage in purchasing an income-producing property can affect the amount of cash required at acquisition, the net cash flows from rental operations, the net cash flows from the eventual sale of the property, and the ultimate return on invested equity. Assuming the going-in IRR is greater than the effective borrowing cost, if an investor increases his leverage rate, say from 75% to 80%, we would expect which of the following to occur?

A) Both NPV and going-in IRR increase
B) NPV decreases, while going-in IRR increases
C) NPV increases, while going-in IRR decreases
D) Both NPV and going-in IRR decrease

Question 20

Based on your understanding of the differences between levered and unlevered cash flows, which of the following is an example of a levered cash flow?

A) Net operating income
B) Net Sale Proceeds
C) Sale price
D) Before-tax cash flow

Question 21

A client has requested advice on a potential investment opportunity involving an income producing property. She would like you to determine the internal rate of return of the investment opportunity based on the following information. Expected Holding Period: 5 years; End of first year NOI estimate: $113,900; NOI estimates in subsequent years will grow by 5% per year; Price at which the property is expected to be sold at the end of year 5: $1,615,205.22; Current market price of the property: $1,475,667.71.

A) -15.30%
B) 8.60%
C) 9.86%
D) 10.00%

Question 22

Given the following information regarding an income producing property, determine the unlevered internal rate of return (IRR). Expected Holding Period: 5 years; 1ˢᵗ year Expected NOI: $89,100; 2ⁿᵈ year Expected NOI: $91,773; 3ʳᵈ year Expected NOI: $94,526; 4ᵗʰ year Expected NOI: $97,362; 5ᵗʰ year Expected NOI: $100,283; Debt Service in each of the next five years: $58,444; Current Market Value: $885,000; Required equity investment: $221,250; Net Sale Proceeds of Property at end of year 5: $974,700; Remaining Mortgage Balance at end of year 5: $631,026.

A) 10.6%
B) 12.2%
C) 22.9%
D) 33.4%

Question 23

Suppose an industrial building can be purchased for $2,500,000 and is expected to yield cash flows of $180,000 each of the next five years (Note: assume payments are made at end of year). If the building can be sold at the end of the fifth year for $2,800,000, calculate the IRR for this investment over the five year holding period.

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

Question 24

Determine the net present value (NPV) of an investment decision to purchase a property for $90,000 that will generate annual cash flows of $10,000 per year for eight years and sell for $80,000 at the end of the eight year holding period, if the appropriate discount rate is 10%? (Note: assume payments are made at end of year)

A) -$2,475
B) - $609
C) + $609
D) +$2,475

Question 25

Given the following information regarding an income producing property, determine the NPV using levered cash flows in your analysis. Required equity investment: $270,000; Expected NOI for each of the next five years: $150,000; Debt Service for each of the next five years: $125,000; Expected Holding Period: 5 years; Required yield on levered cash flows: 15%; Expected Sale Price at end of Year 5: $2,000,000; Expected Cost of Sale: $125,000; Expected Mortgage Balance at time of sale: $1,500,000

A) $245.15
B) $270,245.15
C) $419,264.54
D) $1,435,029.64

Question 26

Given the following expected cash flow stream, determine the NPV of the investment opportunity. Investment Horizon: 3 years; End of first year NOI estimate: $886,464; End of second year NOI estimate: $913,058; End of third year NOI estimate: $940,450; Price at which the property is expected to be sold at the end of year 3: $5,000,000; Current market price of the property: $6,200,000; Discount rate: 9%.

A) -$321,010.66
B) -$28,451
C) +$28,451
D) +$321,010.66

Question 27

Suppose you purchased an income producing property for $95,000 five years ago. In Year 1, you were able to negotiate a lease that paid $10,000 per year at the end of each year. If you are able to sell the property at the end of year 5 for $100,000 (after receiving our final lease payment), what was the internal rate of return (IRR) on this investment?

A) -18.18%
B) 1.03%
C) 9.57%
D) 11.37%

Question 28

Given the following information regarding an income producing property, determine the after tax net present value (NPV). Expected Holding Period: 5 years; 1ˢᵗ year Expected BTCF: $30,656; 2ⁿᵈ year Expected BTCF: $33,329; 3ʳᵈ year Expected BTCF: $36,082; 4ᵗʰ year Expected BTCF: $38,918; 5ᵗʰ year Expected BTCF: $41,839; 1ˢᵗ year Expected Tax Liability: $7,645; 2ⁿᵈ year Expected Tax Liability: $8,658; 3ʳᵈ year Expected Tax Liability: $9,708; 4ᵗʰ year Expected Tax Liability: $10,798; 5ᵗʰ year Expected Tax Liability: $6,951; Estimated Before Tax Equity Reversion at end of year 5: $343,674; Expected Taxes Due on Sale at end of year 5: $32,032; Required equity investment: $241,163; After Tax Opportunity Cost: 11.2%

A) -$40,858
B) -$91,785
C) $40,858
D) $91,785

Question 29

Given the following expected cash flow stream, determine the NPV of the proposed investment in an income producing property and determine whether or not the investment should be pursued. Investment Horizon: 5 years; Expected Yearly Cash Flow in each of the next five years: $127,628. Expected Sale Price at end of 5 years: $1,595,350; Opportunity Cost of Investment 6%; Current Market Price of Property: $1,750,000

A) NPV is -$20,246; Decision is to invest
B) NPV is -$20,246; Decision is not to invest
C) NPV is $249,967; Decision is to invest
D) NPV is $249,967; Decision is to not invest

Question 30

Given the following expected cash flow stream, determine the IRR of the proposed investment in an income producing property and determine whether or not the investment should be pursued using IRR as your decision making criteria. Investment Horizon: 5 years; Expected Yearly Cash Flow in each of the next five years: $127,628. Expected Sale Price at end of 5 years: $1,595,350; Required return on equity: 5%; Current Market Price of Property: $1,750,000

A) IRR is 4.92%; Decision is to invest
B) IRR is 4.92%; Decision is to not invest
C) IRR is 5.72%; Decision is to invest
D) IRR is 5.72%; Decision is to not invest

Question 31

Given the following information regarding an income producing property, determine the after tax internal rate of return (IRR). Expected Holding Period: 5 years; 1ˢᵗ year Expected BTCF: $30,656; 2ⁿᵈ year Expected BTCF: $33,329; 3ʳᵈ year Expected BTCF: $36,082; 4ᵗʰ year Expected BTCF: $38,918; 5ᵗʰ year Expected BTCF: $41,839; 1ˢᵗ year Expected Tax Liability: $7,645; 2ⁿᵈ year Expected Tax Liability: $8,658; 3ʳᵈ year Expected Tax Liability: $9,708; 4ᵗʰ year Expected Tax Liability: $10,798; 5ᵗʰ year Expected Tax Liability: $6,951; Estimated Before Tax Equity Reversion at end of year 5: $343,674; Expected Taxes Due on Sale at end of year 5: $32,032; Required equity investment: $241,163

A) 11.2%
B) 13.3%
C) 15.4%
D) 20.3%

Question 32

Given the following information regarding an income producing property, determine the internal rate of return (IRR) using levered cash flows. Expected Holding Period: 5 years; 1ˢᵗ year Expected NOI: $89,100; 2ⁿᵈ year Expected NOI: $91,773; 3ʳᵈ year Expected NOI: $94,526; 4ᵗʰ year Expected NOI: $97,362; 5ᵗʰ year Expected NOI: $100,283; Debt Service in each of the next five years: $58,444; Current Market Value: $885,000; Required equity investment: $221,250; Net Sale Proceeds of Property at end of year 5: $974,700; Remaining Mortgage Balance at end of year 5: $631,026.

A) 10.6%
B) 12.2%
C) 22.9%
D) 33.4%