Analysis of the Investment Target - Essay Example

Fundamentals of Finance Option Buy to Let Location: Manchester Road, Clifton of Property: It is a 2-bedroomed flat positioned along the Manchester Road, Clifton, situated on the ground floor with a kitchen and lounge, has no chain, collective garden, gas central heating, and double glazing, and family bathroom. The property is a situated in a secure place with drive in checks and within an area dominated by high presence of local authorities and sheriff office. The environment is friendly as the open communal garden is open to the horizon as the property is not surrounded by tall buildings or obstructions from direct view of the sky. Photos: Interior view of one of the master bedrooms showing a spacious area within the room. The outside view of the property showing a cultivated front yard suited with garbage cans and showing spacious distance from one property block to the next. The arrangement of the apartments allows a personal parking lot to the front and a walk through pavement connecting from the main residential interstate roads. Weblink: www.rightmove.co.uk/property-for-sale/property-41518172.html# Purchasing Price: ?59,500 The annual cash flows expected from the investment target is ?850 per calendar month as the area has competitive rental market given that area is spacious and secluded from industrial zones, hence fore, investors in this area are driven by the market valuation of the properties as well as the location which raises the expected valuation of the property to be higher than the market price. The market price of the same property along the Greater Manchester area is set at ?650 with regards to the proximity of properties and roads, shopping malls, security of the area, and demand and supply of rental properties along the same area. However the expected rental amount from this particular property is ?850 as the property is new, all its features are functional and the seclusion from the industrial areas makes the property higher valued than its market competition counterparts. Therefore, for Mr. Priddin to invest in this property, his annual cash flows are calculated as Annual Cash Flows Expected Investment Target: ?850 Per Calendar Month (PCM) = (?850 x 12) = ?10,200 The rationale of providing rental service for ?850 per month is because; after investigating the rental prices for 2 bedroom flats and apartments around the Little Lever Bolton within the Greater Manchester area, it is found out those property rentals per calendar month range from ?150-700 with regards to conditions and luxury facilities. With regards to the presence of communal gardens and the easy access to ground floor apartments, the prices for these properties are kept higher than the market price at either the threshold of ?700 PCM or above at ?1000. With Mr. Priddin expecting a 6% return on investment, the future value of the property is calculated as Perpetuity = (Rental Price x Months in a year)/r Therefore, If Mr. Priddin is to purchase this property at ?59,500 his annual returns would be Perpetuity = (850*12 months)/r = 10,200/0.06 = ?170,000 Hence fore, the present value of the future cash flows of ?170,000 is higher than the current selling price of ?59,500 and is therefore a good investment for Mr. Priddin to invest in. A) If as a landlord Mr. Priddin would like to keep this property and rent it forever raising the rent at the rate of 4%, is it advisable for Mr. Priddin to purchase this property? Then Using P = Co*(1+g)/r-g his return on investment would be calculated with regards to the purchase price of the property C0 divided by the difference between the return on investment and expected less the rate of rent increase per year. P = C1/r-g P = 59500/6% - 4% P = ?2,975,000 With respect to the present value of the future cash flows of ?2,975,000 the purchase price of the property is lower and therefore the property is still worth buying. The difference between the present value of the property and the future cash flows and the purchase price of the property should be viable enough to guarantee return on investment worth more than the property purchase price and maintenance of the property for the entirety of the time a tenant stays in the property. Hence fore, the realized present value for future cash flows provides return on investment of: Expected return on investment = (present value of future cash flows – the purchase price of the property/purchase price of the property) * 1000 = (2,975,000 – 59,500/59,500)*100 = (2915500/59500)*100 = (49)*100 = 4900% return on investment B) If Mr. Priddin decides to keep rents constant forever and he will never sell this buy-to-let property. His required rate of return is still 6%. Is it recommended for him to invest in this property? = (850*12 months)/r = 10,200/0.06 = ?170,000 Expected return on investment for this case with respect to 6% expectation from the investment property is = (present value of future cash flows – the purchase price of the property/purchase price of the property) * 1000 = (170,000 – 59500/59500)*100 = (110,500/59500)*100 = (1.857)*100 = 187.5% return on investment Hence fore, the present value of the future cash flows of ?170,000 is higher than the current selling price of ?59,500 and it is therefore a good investment for Mr. Priddin to invest in the property with respect to the 187.5% return on investment expected from the property by only maintaining a 6% an expected return on investment from the property. Option 2 – UK Gilt” A) If Mr. Priddin would like to purchase this UK Gilt (“GB00B3KJDS62”) on October 23, 2013. How much was the dirty price on that day? Calculation of the dirty price of Gilt or a Bond is a function of the clean price of the bond plus the accrued interest. The clean price is the price for the offer without the accrued interest. With regards to the time of the sale since the last coupon payment, the clean price is mostly likely to have incurred interests and therefore this interest is added to the clean price to make the dirty price. Under the condition that the accrued interest is not given as a figure, its calculation is a function of interest rate multiplied with the amount of time that has passed since the last coupon payment. Hence fore, in calculating accrued interest clean price is multiplied with the number of days since the last coupon payment. The assumption of this calculation is that interest is calculated with respect to daily interest accruing. For the dirty price of the gilts to be calculated with regards to the bond’s last coupon payment and the number of days that have passed – this case however, does not involve interest accrued since the last coupon payment as it is bought on the same day it is available. Gilt price 112.18 With yield of 3.526 and Coupon of 4.25 25 years 10 months Accrued interest = C x No. of days since last coupon payment/ day count base Dirty price = clean price + accrued interest1 = 112.18 + 3.526 = 115.706 B) How much will be the yield if Mr. Priddin purchases this Gilt on October 23, 2013? Assume that Mr. Priddin will hold his investment until maturity. PB = Fmn/(1+i/m)mn2 =1,500,000/(1 + 0.425/1)1 = 1052631.67 C)If Mr. Priddin invests ?1,500,000 in this UK Gilt, how much annual coupon payment could he receive until 2039? PB = 1500000/ (1 + 0.425/39)39 = 1500000/ (0.0365384)39-1 = 1500000/ (8.88564) - 1 = 190,219 D) At maturity in 2039, in addition to the annual coupon payment, will any extra cash flow occur to Mr. Priddin? Effective Annual Yield = (1 + 0.3654/1)1 = 1.03564 = 10.3564% At maturity, in addition to coupon payment, Mr. Priddin will still have extra cash flow. Option 3: Shares of Burberry a) Capital Pricing Model The rate on a risk free security risk premium equal and the return of a security or a portfolio are equal. In case the expected return does not beat the required return the investment is not advisable3. b)Expected return for the shareholders of Burberry given that beta is 1.1516 with risk free rate of UK, 2.937% with market return share is 11.187% Risk free rate 2.93, beta of 1.11516 with expected market return of 11.187% = (2.93+1.1516(11.187-2.293)) = 2.93+1.1516(9.577) = 4.446(9.577) = 42.579342% In this case, the investment is viable and therefore Mr. Priddin can invest on the option expecting a 42.579342% returns. Had the investment showed expected returns to be 0% or negative, then the investment would not be advised as the objective of investment is to sustain revenue generation. The expected return on investment should also be high enough to guarantee sustainability of the investor. For example, had the return on investment been 10% or less, then Mr. Priddin would make a decision to either abandon the investment option if his expectation was higher than the acquired figure. c) The security market line for Mr. Priddin Graph 1: Security Market Line Graph 1: Security Market Line The Security Market line presents an investor with the insight on how to calculate return on investment with regards to stocks bought and the expected market returns within the stock market. This calculation involves the finding of the gradient or the slope on the graph. In this case, the gradient of the line representing Gradient = ?Y/?X4 ?Y = Y0 – Y/ ?X = X0 –X1 ?Y = 0 – 0 ?X = 11.187 – 1.1516 = 0 – 0 / (11.187 – 1.1516) = 0/10.0354 = 0 With regards to the fact that there are no values for the Y axis makes the calculation of the gradient impossible for the slope. This means that the security line presents no level of threats at its present form5. Graph 2: security risk versus expected return The market share return expectation has its peak on the line drawn, high above those of beta and free risk security showing that the shares have been overvalued and that customers may not acquire their expected levels by investing. Therefore, the buying of bonds with the return expectation of 11.187 is a dangerous strategy as the share value if not satisfactory to the customer6. In addition the 0% risk found on the initial security line gradient shows that if no risks are involved, then the investment is not likely to accrue any benefits and therefore is a bad investment as investors would expect returns from their investment rather than neutrality of the investments. Neutral investments show that the investment in the stock market has nothing to expect from as expected returns are either zero or negative7. Conclusion If Mr. Priddin is to purchase the Manchester road property at ?59,500 his annual returns would be ?170,000 and a corresponding return on investment of 187.5%. Hence fore, the present value of the future cash flows of ?170,000 is higher than the current selling price of the property of ?59,500 and is therefore a good investment for Mr. Priddin to invest in. With respect to the present value of the future cash flows of ?2,975,000 the purchase price of the property remains lower and consequently the property is worth buying as a corresponding return on investment of 4900% is expected from the investment. With regards to option two of investing in UK Gilt shows that at maturity, in addition to coupon payment, Mr. Priddin will still have extra cash flow. And therefore stands as a viable option to adapt although it does not beat the expected returns of option 1. Therefore, the expectation on option 1, of ?2,975,000 from an investment of ?59,500 beats the expectation of option 2 of 42 percent returns from buying Burberry shares. Therefore, Mr. Priddin should choose option 1 over the rest of the investment options. Bibliography Khan and Jain. Financial Management. Tata McGraw-Hill Education, 2007; 141-155 Read More