Question

You are a commercial real.estte broker, eager to sell an office building. An investor is interested but demand 20% return of her equitt investment. The building's selling price is 25 Million Pesos, and it promises free cash flows of 3 Million pesos annually in perpetuity. Interest only financing is available at 8 percent interest; that is; the debt is ourstanding forever amd requires no principal payments. The tax rate is 50 percent.
a. Propose an investment finnacing package that meets the investors return target.
b. Propose an investment financing package that meets the investors target when.she demands a 90 percent returns on equity.
c. Why would an investor settle for 20 percent rwturn on this investment when she can get as high as 90 percent.

Answer 1

Assumed	Debt	=	x
	equity	=	y
	return on equity	=	0.20y
	cost of debt	=	(0.08-(1-t)x)
		=	(0.08(1-0.5)x)
		=	0.04X
	free cash flow	=	3
	Total investment	=	25
	or
	X+Y	=	25
	y	=	25-X (First equation)
	Return	=	Cost of debt+desired return of equity
	3	=	(0.04X)+(0.20Y)
	0.20Y	=	3-0.04X (Second equation)
	Replacing value of first equation in second equation
	0.20(25-X)	=	3-0.04X
	5-0.20X	=	3-0.04X
	5-3	=	0.20X-0.04X
	2	=	0.16X
	X	=	2/0.16
	X	=	12.5
a	Capital structure for achieving 20% return
	Debt	12.5
	Equity	12.5
	Check
	Interest after tax		(Debt X rate of interest( 1-Tax Rate)
		=	12.5 X 8% (1-.50)
		=	0.5
	Free cash flow after interest	=	Cash flow- interest expense
		=	3-0.5
		=	2.5
	Return on equity (In percentage)	=	Total return/Total equity X100
	Return on equity (In percentage)	=	2.5/12.5*100
	Return on equity (In percentage)	=	20
b	When 90% return is required
	current second equation is
	0.20Y	=	3-0.04X (Second equation)
	Replacing desired return
	0.90Y	=	3-0.04X (Third equation)
	Replacing value of first equation in third equation
	0.90(25-X)	=	3-0.04X
	22.5-0.90X	=	3-0.04X
	22.5-3	=	0.90X-0.04x
	19.5	=	0.86X
	X	=	19.5/0.86
	X	=	22.6744186
	Check
	Interest after tax		(Debt X rate of interest( 1-Tax Rate)
		=	22.6744X 8% (1-.50)
		=	0.906976
	Free cash flow after interest	=	Cash flow- interest expense
		=	3-0.906976
		=	2.093024
	Return on equity (In percentage)	=	Total return/Total equity X100
	Return on equity (In percentage)	=	2.093024/(25-22.6744)*100
	Return on equity (In percentage)	=	90
Reasons for selecting less return on equity than higher
1)	It requires higher amount of equity (own money ) to invest.
2)	Less tax benefit available as return on equity is fully taxable whereas interest deductible expense in taxation.
3)	Cash flow does matter as in the instant case it can be seen that less equity investment provide high free cash flow.
4)	Cost of debt when cost of debt is less than cost of equity it is better to opt debt mix proposal.