Question

Suppose that you are considering an investment in an apartment building. The specifics are:                                                            
- The building is four years old, has a 85 percent occupancy rate, and has an expected useful life of 25 years. Assume that this occupancy rate is expected to continue for the life of the building.
- There are 130 2-bedroom units, 100 1-bedroom units, and 70 studios.
- The 2-bedroom units rent for $2800 per month, the 1-bedroom units for $2000 per month, and the studios for $1200 per month.
- Current rent control laws will prevent the rents from ever being raised.
- The estimated annual maintenance cost for the building is $1500000 per year (this is independent of the number of apartments rented).
- There is an additional estimated maintenance cost at $200 per unit per month, when each unit is rented.
- There will be no salvage value to the building in 25 years, but it is estimated that it will cost 6 million dollars at that time to demolish the building as will be required in the purchase contract. (You are not purchasing the land. You will have a 25-year lease of the land, which is paid for in the purchase of the building.)      
- The asking price of the building is $30 million.
- The tax-rate is 30%, and assume the building will be fully depreciated over its useful life.
- The WACC is 9%.                                                                   
Develop the pro-forma income statement, compute the Operating Cash-Flows and NPV. Assume that your bossy boss wants you to do a sensitivity analysis regarding the project. He is concerned that the vacancy rate may increase by as much as 5% (occupancy will go down to 80%). Compute the NPV for this scenario (round to nearest $10,000).

Answer 1

1.)

The NPV of the investment is 3970000 (rounded to nearest 10000)

Step 1: - computation of Net income

INCOME STATEMENT

sales	[(130*2800+100*2000+70*1200)*.85*12]	= 6609600
variable costs	[300*200*.85*12]	= 612000
Fixed costs		= 1500000
Depreciation	[35,000,000 / 25 ]	= 1200000
EBIT		= 3297600
interest		= 0
EBT		= 3297600
Taxes	[30%]	= 989280
Net income		= 2308320

Step 2: - computation of operating cash flow

Operating cash flow = Net income + Depreciation

= 2308320 + 1200000

=3508320

Step 3: - computation of NPV

Before calculating NPV we have to calculate after-tax cost of demolishing

after-tax cost of demolishing = 6000000 * (1-.3)

after-tax cost of demolition = 4200000

The NPV of the investment is positive. therefore, accept the investment.

2. Sensitivity analysis (occupancy rate = 80%)

The NPV of the investment when occupancy will go down to 80% is 1540000 (rounded to nearest 10000)

Step 1: - computation of Net income

INCOME STATEMENT

sales	[(130*2800+100*2000+70*1200)*.80*12]	= 6220800
variable costs	[300*200*.80*12]	= 576000
Fixed costs		= 1500000
Depreciation	[35,000,000 / 25 ]	= 1200000
EBIT		= 2944800
interest		= 0
EBT		= 2944800
Taxes	[30%]	= 883440
Net income		= 2061360

Step 2: - computation of operating cash flow

Operating cash flow = Net income + Depreciation

= 2061360 + 1200000

=3261360

Step 3: - computation of NPV

The NPV of the investment is positive. therefore, accept the investment.