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

Lets understand the case :

Position before covid19-Sam was earning a rental income of$100000 by renting the propery to a travel agent.

Position after Covid 19= Travel agent shut the business due to which ultimately Sam’s rental income stopped

Now Sam plans for a investment opportunity

Lets see what alternatives he has:

1^St alternative:Taking advantage of rising demand of sanitizer and tissues in covid 19 SAM has a production plan these with certain costs and revenue( discussed in financial anlaysis)

2^nd alternative: If he invests in an investment with similar risk he will get a return of 8%

Lets understand the meaning of terms used

Finance cost :this is considered as the borrowing cost eg interest cost

Opportunity:the cost that is foregone for choosing an alternative investment.

Financial analysis

Alternative 1

COST=$5M

Interest=6%

Finance Cost=$300000 per annum (5m*6%)

CASH inflows=$800000 per year (given)

Cash outflows=$300000 per year (interest)

Net cash inflows=$500000 (800000-300000)

Hence this will be for 10years

Lets analyse the present value at 8%

that is interest rate today in market (commonly called opportunity cost)

Discounting factor (1/1.08^1, 1/1.08^2……..)

1	0.9259
2	0.8573
3	0.7938
4	0.7350
5	0.6806
6	0.6302
7	0.5835
8	0.5403
9	0.5002
10	0.4632

=500000*6.7101=$3355050

NPV=5000000-3355050= - $1644950

value of inflow is lower than outflow project not acceptable due to negative net present value.

Hence to understand the impact of finance cost and opportunity cost:

Finance cost in the above case is 6% that is the interest being an obligation which has to be paid to the bank.Its impact on the project is such that it involves an annual outflow of cash however if taxation is taken into consideration it gives tax benefit to the investor as tax saving by reducing profit.

Opportunity cost:if investor decides to invest in market today it will give him interest of 8% hence in capital budgeting this present market interest rate is used as a discounting factor to help the investor analyse present value of his annual cash inflow and when compared to his outflow, he can analyse his NPV

Which if +ve investor should accept the project if negative investor should reject.

Therefore 8% forms a parameter to see the value of money today in market.

(to understand clearly if the cash of was invested in market for 10years.. what would be the value today?It is shown by 8% as investor is foregoing the option of investing in market hence he is finding present value as per market interest rate)

I request to you to please ask any doubt you have i will reply. you may ask anything not clear i will explain.

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