Question

(Value of Investment) Your real estate adviser has come back with some revised forecasts. He suggests that you rent out the building for two years at $30,000 a year, and predicts that at the end of that time you will be able to sell the building for $840,000. Thus there are now two future cash flows—a cash flow of C1 = $30,000 at the end of one year and a further cash flow of C2 = (30,000+840,000) = $870,000 at the end of the second year.

a) What is the present value of the property? Shareholders still have two financial assets to choose: a safe asset with rate of return 8% and a stock with expected rate of return 12%.

b) Suppose a banker approaches. “Your company is a fine and safe business with few debts,” she says. “My bank will lend you the $700,000 that you need for the office block at 8%.” Does this mean that the opportunity cost ofinvestment is 8%? .By investing in the office building you are giving up the opportunity to earn an expected return of 12% in the stock market. Which is your opportunity cost? If you were the financial manager,will you take the banker’s loan?

Answer 1

Answer (a):

Year 1 Cash flow = C1 = $30,000

Year 2 Cash flow = C2 = $30000 + $840000 = $870,000

The risk level of the Office Block project is comparable to risk level of assets with returns of 8%.

It is appropriate to use 8% as rate of discount.

Present value of the property = 30000 / (1 + 8%) + 870000 / (1 + 8%) ² = $773,662.55

Present value of the property = $773,662.55

Answer (b):

Opportunity cost of investment is the rate of return the shareholders can get by investing in opportunity available with the similar level of risk. The risk level of project is comparable to 'safe asset' which gives rate of return 8%. As such opportunity cost will be 8%. Although stock has expected rate of return of 12% the risk level is higher and as such not comparable. Hence opportunity cost is 8% not 12%.

To evaluate whether to take bankers loan or not, let us calculate NPV of the project:

NPV = PV of cash flows - Initial investments = 773662.55 - 700000 = $73,662.55

As such the project has positive NPV of $73,662.55 at discount rate of 8% and is acceptable.

Yes, If I were the financial manager, I shall take the banker’s loan and go ahead with the project.