Question

Kartman Corporation is evaluating four different real estate investments. Management plans to buy the properties today and sell them three years from today. The annual discount rate for these investments is

13%.

The following table summarizes the initial cost and the sale price in three years for each​ property:

	Cost Today		Sale Price in Year 3
Parkside Acres	$610,000		$1,110,000
Real Property Estates	970,000		1,570,000
Lost Lake Properties	600,000		1,000,000
Overlook	110,000		310,000

Kartman has a total capital budget of

$720,000

to invest in properties. Which properties should it​ choose?

Answer 1

The real estate investments can be evaluated by finding their IRR (internal rate of return)

Present value of Sale price in year 3 = Cost Today

Sale price in year 3 / (1+r)³ = Cost Today

Where r is the IRR

(1+r)³ = Sale price in year 3 / Cost Today

1+r = (Sale price in year 3 / Cost Today)^(1/3)

r = (Sale price in year 3 / Cost Today)^(1/3) - 1

IRR of Parkside acres = ($1,110,000 / $610,000)^(1/3) - 1 = (1.819672131)^(1/3) - 1 = 1.220855829 -1 = 0.220855829

= 22.09%

IRR of Real Property Estates = ($1,570,000 / $970,000)^(1/3) - 1 = (1.618556701)^(1/3) - 1 = 1.174111403-1 = 0.174111403 = 17.41%

IRR of Lost Lake Properties = ($1,000,000 / $600,000)^(1/3) - 1 = (1.666666667)^(1/3) - 1 = 1.185631101 -1 = 0.185631101 = 18.56%

IRR of Overlook = ($310,000 / $110,000)^(1/3) - 1 = (2.818181818)^(1/3) - 1 = 1.412503945 -1 = 0.412503945 = 41.25%

IRR is highest for Overlook and Parkside acres and Kartman has a capital budget of $720,000

Total cost to invest in Overlook and Parkside acres = $110,000 + $610,000 = $720,000

Hence Kartman can investment in Overlook and Parkside acres investments