Chapter 19 Investment Decisions: NPV and IRR McGraw-Hill/IrwinCopyright © 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 1 st 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 must 1.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

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, Equity = $885,000 - $643,837.5 = $241,163 Payment: $4, or $58,444 per year

19-10 Centre Point with Mortgage Financing $41,838

19-11 Present Value of Levered Cash Fl ows Justification for increasing discount rate from 11.75% to 16%?

19-12 Net Present Value of Centre Point NPV = PV in − PV out NPV = $279,354 − $241,163 PV out 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 %, 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%: ( – 15.4) ÷ = 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 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 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