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Chapter 19
Investment Decisions: NPV and IRR
McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
19-2
Overview
Major theme: most RE decisions are made with an investment motive magnitude of expected CFs--and the values they
create—are at the center of investment decision making
Chapter 18 focuses on widely used, single-year, return measures, ratios, & income multipliers
These criteria are relatively easy to calculate & understand—an advantage in the eyes of many industry professionals
19-3
Overview
Limitation of these single-year return measures & ratios? They do not incorporate income producing ability of
property beyond the 1st year of rental operations May lead to suboptimal investment decisions
19-4
Overview
Many investors also perform multi-year analyses of potential acquisitions
When using multi-year discounted CF decision making methods, investor must1. estimate how long she expects to hold property
2. make explicit forecasts of: property’s net CF for each year, net CF produced by expected sale of property
3. Select rate of return at which to discount all future CFs
19-5
Centre Point Office Building
19-6
Centre Point: 5-Year Operating Pro Forma
19-7
Centre Point: Reversion Sale Price
10.0
NOI000,033,1$
6
10.0
291,103$000,033,1$
19-8
Levered vs. Unlevered Cash Flows
Levered CFs measure property’s income after subtracting mortgage payments
Valuation of levered CFs? Discount expected BTCFs rather than stream of NOIs
Why is owner’s claim on a property’s CFs refereed to as a “residual claim”?
19-9
Effects of Leverage on Centre Point Equity Investment & Future Cash Flows Loan Terms
75% loan, 30 years, 8%, total up-front fees of 3%
Net loan proceeds:
= $663,750 − (0.03 x 663,750)
= $643,837.50 Equity = $885,000 - $643,837.5 = $241,163 Payment: $4,870.36 or $58,444 per year
19-10
Centre Point with Mortgage Financing
$41,838
19-11
Present Value of Levered Cash Flows
Justification for increasing discount rate from 11.75% to 16%?
19-12
Net Present Value of Centre Point
NPV = PVin − PVout
NPV = $279,354 − $241,163
PVout in this example is equal to original equity investment of $241,163
NPV = $38,191
Decision: Take on Centre Point investment because doing so will increase equity investor’s wealth by $38,191
19-13
Effect on NPV of Variation in Required Yield/IRR
At a discount rate of 20.2584%, NPV = 0, this is the going-in IRR
19-14
Why IRR Is Technically Inferior to NPV as a Guide to Investment Decisions IRR & NPV will always give the same accept-
reject signal w.r.t. an individual investment But…..
IRR may rank investment opportunities differently than NPV
If projected CFs change signs more than once over expected holding period, there may be multiple IRRs
19-15
Leverage Can Increase Both NPV & IRR
But…leverage also increases risk, thus required equity return (review related discussion in Chapter 16)
19-16
Impact of Leverage on Investment Risk
19-17
Reality Checks on Investment Value
Claim of project organizer (promoter) on returns Compensation for idea, time, effort, & knowledge
Claim of taxes on returns Federal taxes (IRS): Up to 35% State taxes: Up to 10% Complexity of tax computations
19-18
Centre Point: After-Tax Cash Flows
Assumed income tax rate on additional income: 30%
19-19
How is Required After-Tax Discount Rate Determined? Assume: required before-tax return = 16% Assumed income tax rate on additional income = 30% After-tax required return = 16% − (0.30 x 16%)
= 16 (1 − 0.30) = 11.2%
That is, after-tax required return = Before-Tax Required
Return x (1−MTR) MTR is investor’s “marginal” tax rate
19-20
Centre Point: After-Tax NPV & IRR
Note: IRR falls less than 30%: (20.258 – 15.4) ÷ 20.258 = 0.24
19-21
Comparison of Three Scenarios
Some conclusions: Leverage increased expected Centre Point equity returns
Each dollar of debt cost 8% but produced 12.2% for equity investor
Taxes significantly reduce net investor CFs
19-22
More Detailed Cash Flow Projections The pro formas detailed in Exhibits 18-2 through
18-12 display major categories of revenues & expenses
However, most RE pro formas provide significantly more detail on projections of revenue sources vacancies operating expenses capital expenditures
See Exhibit 19-15 for an example
19-23
Varying the Assumptions
Sensitivity analysis Most likely scenario Worst-case scenario Best-case scenario
Value of computer Excel spreadsheets Specialized software such as ARGUS
Monte Carlo simulation
End of Chapter 19