Deck 19: Investment Decisions: NPV and IRR

Question 1

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

Answer 1

A

Question 2

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

Answer 2

A

Question 3

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.

Answer 3

C

Question 4

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 5

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 defensible cash flow estimates that incorporate appropriate measures of income and expenses,long-term trends,comparable properties,and social / legal environment conditions.

Question 6

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 7

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 8

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 9

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 10

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

Question 11

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 12

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 13

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 14

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.

Question 15

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

Question 16

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 17

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 18

Which of the following terms refers to the present value of the right to receive a lump sum payment of $1 at the end of a particular year,given a specified discount rate?

A)Net present value
B)Present value factor
C)Future value
D)Net operating income

Question 19

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 20

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: $1,350,000.

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