AB is a contractor, working in the NJ area, contemplating a real estate investme
ID: 2814376 • Letter: A
Question
AB is a contractor, working in the NJ area, contemplating a real estate investment. The idea would be to purchase and remodel the "Jersey Mansion", a large house with 7 rental units. AB has obtained the following information The market price of the house is $180,000 . Remodeling the house would cost $140,000 (paid at the time of the purchase) and it would take one full year. . Once remodeled, AB plans to rent each unit for $12,000 per year (paid at the beginning of the year) *AB will pay 2.5% of the current market price of the house in property taxes (paid at the beginning of every year once remodeled) . AB will do all the administrative work and all the maintenance work by himself. In order to do so, he would spend 300 hours per year and would reject other jobs in which he could make $40/hour. . AB has so far spent $15,000 searching for potential real estate investments. . The discount rate is 12%. QUESTIONS: a. What is the size of the initial investment? How much are revenues per year? How much are costs per year (excluding initial investment)? b. If AB keeps the house forever, what is the internal rate of return of the project? c. If AB keeps the house forever, what is the NPV of the project? d. If AB keeps the house forever, is buying the house an acceptable investment?Explanation / Answer
(a-1) Computation of the size of the initial investment.We have,
Size of the initial investment = Market price of the house + Remodelling cost of house
Size of the initial investment = 180,000 + 140,000 = $ 320,000
(a-2) Computation of the revenue per year.We have,
Revenue per year = Rental price per unit x Number of units
Revenue per year = 12,000 x 7.00 = $ 84,000
(a-3) Computation of the cost per year of the house.We have,
Cost per year = Property taxes + Administrative Cost
Cost per year = (180,000 x 2.5%) + (300 x 40) = 4,500 + 12,000 = $ 16,500
(b) Computation of the internal rate of return(IRR) of the project.We have,
Step1: Computation of the present value of cash inflow for the project.We have,
The house is possessed by AB for forever.
At 12% Cost of capital:
Present value of cash inflow =( Total revenue - Total cost) / Cost of capital
Present value of cash inflow = ( 84,000 - 16,500) / 0.12
Present value of cash inflow = 67,500 / 0.12 = $ 562,500
At 25% Cost of capital:
Present value of cash inflow =( Total revenue - Total cost) / Cost of capital
Present value of cash inflow = ( 84,000 - 16,500) / 0.25
Present value of cash inflow = 67,500 / 0.25 = $ 270,000
Step2: Computation of the IRR of the project.We have,
IRR = r - [ ( Cash outflow - PV of CFAT(25%)) / ( PV of CFAT(12%) - PV of CFAT(25%) ] x difference in interest rate
IRR = 25 - [ (320,000 - 270,000)/ ( 562,500 - 270,000) ] X (25 -12)
IRR = 25 - [ 50,000 / 292,500 ] X 13
IRR = 25 - 2.22
IRR = 22.78 %
(C) Computation of the net present value of the project when required return 12%.We have,
NPV = Present value of cash inflow - Cash outflow
NPV = 562,500 - 320,000
NPV = $ 242,500
(d) When the project IRR is greater than required return. The prject should be accepted. In this question, project IRR is 22.78 % which is greater than required return 12%.So, project should be accpeted as per IRR criterion.
When the project NPV has positive value.The project should be accepted. In this question, the project NPV is $ 242,500. So, the project should be accpted as per NPV criterion.
Size of the initial investment $ 320,000