Based on lectures 7-9
Question 1. You have identified a vacant piece of land with a planning permission to build a block of flats, which you can purchase for £6 million (payable immediately). According to your research, the construction will take one year and will cost £3 million (which will need to be paid at the end on year 1).
Once the building is completed (at the end of the first year), you plan to rent it out for 3 years at annual profit of £800,000 after all expenses. This income will be received at the end of each of three years following the completion of the development. You hope to sell it for £10.8 million at the end of fourth year.
⦁ Using a table lay out the stream of CFs from this project. Clearly indicate the correct period, cash inflows / outflows, and the source of each CF. Calculate total CFs for each period. (10 marks)
CF (Year 0) CF (Year 1) CF (Year 2) CF (Year 3) CF (Year 4)
Purchase price (6,000,000) – – – –
Construction cost – (3,000,000) – – –
Rental income – – 800,000 800,000 800,000
Sale price – – – – 10,800,000
Total CF (6,000,000) (3,000,000) 800,000 800,000 11,600,000
⦁ Assume that an alternative investment can generate 6.5% return, calculate the NPV from this project. Show your work by setting the complete NVP equation. (6 marks)
Answer: NPV = £1,567,653
NPV = PV of cash inflows – PV of cash outflows
NPV = PV(CF in year 0) + PV(CF in year 1) + PV(CF in year 2) + PV(CF in year 3) + PV(CF in year 4) =
NPV = – 6,000,000 – 2,816,901 + 705,327 + 662,279 + 9,016,948 = 1,567,653
⦁ Should you undertake this project? Explain why or why not? (4 marks)
Yes, you should invest in this project.
This project is increasing investor’s wealth since NPV at a current discount rate is positive (+£1,567,653). It implies that the present value of all cash inflows generated by this investment is higher than the present value of all outflows required. In other words, by sacrificing some amount of money today (buying the plot of land) and paying in additional sum in year 1 (construction costs), you are generating higher return from future rents and building resale value (in today’s money terms). You are buying an asset for a sum that is £1,567,653 lower than what it is actually worth based on future cash flows it can generate.
This reasoning, of course, is only correct assuming that the discount rate, future rents and resale value are known with certainty.
⦁ Apart from this construction project, you are also considering an alternative: just holding this vacant plot of land and selling it in 4 years to another developer. Then you would miss out on the rental income from the building, but also avoid any construction costs. There are no direct expenses associated with holding this land and you expect to sell it for £8.1 million. Which plan should you pursue (if any)? Explain your reasoning with reference to NPV of each project. (10 marks)
Question 2.
You are considering a property deal in Walsall with the following CF forecast:
⦁ Using Excel, work out the actual rate of return (IRR) from this investment. (10 marks)
⦁ While looking for profitable deals you came across another opportunity in Manchester with a 30% internal rate of return over the same 3-year investment period (much higher than the one you found above). You only have enough funds to finance one of the projects. Based on the information provided, which project would be a better investment? Explain your reasoning. (10 marks)
Answer:
You cannot determine which project is a better investment (more profitable), unless they are of equal size.
