Question

Assume you are considering a proposal to buy an old house in the Netherlands to convert into 5 luxury rental apartments and hold it as an investment so that you create regular income for the next 5 years. The estimated cost of the house and the renovations would be about €400,000.

Cash flow analysis. Use the direct or indirect method. Present your calculations and discuss the findings.

1. Capital structure & cost of capital analysis: estimate the overall rate of return (WACC). Make assumptions about your capital structure mix. How are you going to finance the investment? Determine which financing sources you’ll use and discuss how the capital structure mix affects the WACC. Present your calculations and discuss the findings.
2. Capital budgeting analysis: Discuss which methods of Investment appraisals (at least 2) you will use to evaluate your project and why you have chosen those (advantages and disadvantages). Present your calculations and discuss the findings.
3. Shareholder value analysis: Assume that after 5 years, you want to sell the property. How will you measure your company’s commitment to value? Which method will you use and why? What would be the minimum price or rate of return you’ll accept? Present your calculations and discuss the findings.
4. Risk analysis: every investment is exposed to significant risks. Name and discuss the risks (at least 2 risks) associated with this specific investment and your strategy towards these risks.

Do not consider taxation in your calculations.
Assume banks charge 3% interest on borrowings
Make assumptions and/or research for the main elements you want to include in your calculations e.g. your own expected return on equity, rent prices, monthly costs, risk factors, growth rates etc.
Please note!!! do not only present your calculations. A system of logic should be used in writing where you discuss your findings (on calculations) and make recommendations.

Answer 1

Initially it is important to clarify that there is an difference between accounting and finance. Accounting records past events and is the discipline responsible for generating the information necessary for the mandatory presentation of financial statements, incluiding the cash flow statement. While finance, project future cash flows through the cash budget (short term) and capital budget (long term).

The Direct and Indirect Methods discussed there are wats to present the mandatory financial statement (cash flow statement). For our case study, none of the methods apply because what you need are future cash flows to see if your investment decision is good and you should make it.

Capital structure and capital cost analysis. The weighted average cost of capital (WACC) theoretically represents the weighted average of the costs of the different financing sources that you will cost you, also represents the minimun return that the investment must have to cover these financial costs. It is determined from the following equation: WACC = wd*kd + we*ke

Where "w" are the weights of each source of capital and "k" are the costs of each source. For example:  

wd = debt weigh ; kd = cost of debt ; we = equity weight; ke = equity cost

Theoretically, it is cheaper to finance with debt because it has a fiscal benefit but a lot of indebtedness represents greater risk.

Investment evaluation method. The Net Present Value (NPV) would be chosen and the Internal Rate of Return (IRR) would be the confirmartion method.

The NPV because it considers the Value of money over time and is calculated by subtracting the initial investment (€400,000) of an investment from the present value of its discounted cash flows at a rate equal to the cost of capital (which in our case will be the WACC).

The IRR, which is a complex capital budgeting technique and also take into consideration the value of money over time. The IRR represents a discount rate that equates the net present value of the cash flows with the initial investment (€400,000), which causes the NPV to ve equal to 0.