Question

A newly-built business property, containing space for a store and two offices, can be purchased for

P1, 200, 000. A prospective buyer estimates that during the next 10 years he can obtain annual rentals of at least P458, 460 from the property and that the annual out-of-pocket disbursements will not exceed P60, 000. He believes that he should be able to dispose of the property at the end of 10 years at not less than P700, 000. Annual taxes and insurance will total 2.5% of the first cost.

(a) Assume he has sufficient equity capital to purchase the property, and that the average return he is obtaining from his capital is 20%. Would you recommend the investment? Use ROR method. Briefly discuss your conclusion. No need to draw the cash flow diagram for this portion.(10 pts.)

(b) What recommendation would you make if he had to borrow 25% of the required capital, on the basis of a 10-year amortization with interest of 18%? Use Annual Worth Method (10 pts.)

(c) If the entire capital can be obtained by floating bonds at 15% that will mature in 10 years, what would you recommend? Sinking fund interest is 15%. Use ROR method. Briefly discuss your conclusion. No need to draw the cash flow diagram for this portion. (10 pts.)

Answer 1

Solution

A.)

Annual revenue  = P458, 460

Annual cost:

Depreciation = P1, 200, 000-P700, 000F A, 20%, 10 = P19, 260

Disbursements =   60, 000

Taxes & insurance = P1, 200, 000(0.025) = 30, 000

Total annual cost                             P109, 260

Net annual profit                  P349, 200

Rate of return = P349, 000P1, 200, 000 x 100 =         29.1 >20%

The investment is justified.

.

B.

Annual revenue  = P458, 460

Annual cost:

Depreciation = P900, 000-P700, 000F A, 20%, 10                      = P7, 700

Amortization = P1, 200, 000 (0.25)P A, 18%, 10             = 66, 760

Disbursements = 60, 000

Taxes & insurance = P1, 200, 000 (0.025) =30, 000

Total annual cost  = P164, 460

Net annual profit  = P294, 000

Rate of return = P294, 000P1, 200, 000 x 100 = 24. 50% > 20%

The investment is justified.

.

C.

Annual revenue  = P458, 460

Annual cost:

Sinking fund deposit = P1, 200, 000-P700, 000F /A, 15%, 10 =             P24, 630

Bond interest = P1, 200, 000 (0.15)                      180, 000

Disbursements                                                         60, 000

Taxes and insurance = P1, 200, 000 (0.025) =   30, 000

Total annual cost                 P294, 630

Net annual profit                  P163, 830

Rate of return =P163, 830P1, 200, 000 x 100 = 13. 65% < 20%

            The investment is not justified.