Question

Your friend, Sam had a rental property rented to a travel agent The property used to generate rental revenues of $100000 per annum. Due to COVID19, the travel agent shut down the business and moved out of the property. Instead of renting it again to a new tenant, Sam is planning for an investment opportunity. He plans to use the property for producing toilet tissues and hand sanitizer to take advantage of recently increased demand for these products in the stir of COVID19. To set up the new business, it will cost him $5m now ( equipment including set up), and he will have to take a bank loan for the whole amount with an interest rate of 6% per annum. The investment will generate an expected cash flow of $800000 per year for ten years. An alternative investment with similar risk generates an expected return of 8% per annum. Your friend seeks your assistance to understand the effect of finance cost and opportunity cost in his capital budgeting decision making. Explain to your friend the impact of these two costs in his project evaluation.

Answer 1

Finance cost is the cost of the finance acquired to fund a project.

Cost of finance is the regular interest paid on the prinicipal borrowed, till it is returned to the lender.

This is given for using that money , at an agreed rate , for an agreed period of time.

This rate is called the cost of the capital --with which the project is started & sustained.

So, the cash inflows /revenues from the project , can be measured by discounting them , with this cost of capital.

Here that relevant financing cost or interest rate is 6%

Opportunity cost is the benefit from some alternative , foregone , due to deciding to go ahead with this project.

That benefit foregone , is the cash inflow sacrificed--- so treated as negative cash ,similar to cash outflow for this project.

In the given case, the rental revenues of $ 100000 need to be sacrificed/ or will be lost, if the property is used for this project.So, $ 100000 is the opportunity cost of rental revenues, lost.

The return expected to be generated by another alternative investment with similar risk , ie.8% should be the bench mark , against which , this project's cash flows should be assessed.

That is, 8% is the minimum acceptable rate of return, MARR

$ 5 million is the initial cost

& the project generates, $ 800000 per year for 10 years.

So, if we tabulate the figures,

Year	0	1	2	3	4	5	6	7	8	9	10
Initial investment	-5000000
Annual cash flows		800000	800000	800000	800000	800000	800000	800000	800000	800000	800000
Opportunity cost of rental income lost		-100000	-100000	-100000	-100000	-100000	-100000	-100000	-100000	-100000	-100000
Net annual Cash flows(FCFs)	-5000000	700000	700000	700000	700000	700000	700000	700000	700000	700000	700000
PV F at 6%(1/1.06^ Yr.n)	1	0.94340	0.89000	0.83962	0.79209	0.74726	0.70496	0.66506	0.62741	0.59190	0.55839	7.36009
PV at 6%	-5000000	660377	622998	587733	554466	523081	493472	465540	439189	414329	390876
NPV at 6%	152061
IRR(Of FCF row)	7%

So, the project generates POSITIVE NPV

& its IRR 7% > Cost of capital 6%

but less than the MARR, 8%

So,the project can be accepted on the premise, that it covers costs ,

if, not earning like the alternative available.