Property Investment Analysis and Discounted Cash Flow - Term Paper Example

Contents Contents 1 INTRODUCTION 2 “DISCOUNTED CASH FLOW” 3 “INTERNAL RATE OF RETURN”, IRR 3 The decision criterion based on IRR 4 “NET PRESENT VALUE”, NPV 5 Decision criterion 5 JUSTIFICATION 6 The impacts of leverage, risk and tax in property investment analysis 6 LEVERAGE 6 RISK 7 TAX 7 RECOMMENDATION 7 CONCLUSION 8 REFERENCES 9 St. George, (2011) Tools Calculators and FAQs, retrieved 2nd June, 2011, 9 EXECUTIVE SUMMARY Analysis of property investment is a very important task, using the various techniques for appraising an investment project like the “pay back period”, “accounting rate of return”, profitability index, “net present value”, and “internal rate of return”. Some of these techniques use the discounted cash flows while others do not recognize the time value of money. This report uses the “discounted cash flows” methods in appraising the property investment. The report utilizes the techniques of “net present value” and “internal rate of return” and from the results a sensible decision on whether to invest or reject investment in the property is made (Carao and Hernandez, 1992). INTRODUCTION Before an investment in property is thought of it is always necessary to determine whether the investment in contemplation is a viable investment project or not. This is better accomplished through the use of the different techniques used in the analysis of property investment. This report analysis the viability of investment in 222 Wyndham Street, Alexandria using the adjusted cash flows (the resultant cash flows after having factored in the time value of money) or “discounted cash flows” methods namely; “net present value”, and “internal rate of return”. The report has also considered the likely impact of leverage, risk and tax on the property investment analysis. The report makes some recommendations based on the analysis of investment in 222 Wyndham Street, Alexandria and winds up by making reasonable conclusion about the viability of investment in 222 Wyndham Street, Alexandria. “DISCOUNTED CASH FLOW” The cash flows from a project do not stream at the same time and therefore, they can never be the same even if the figure is the same. This is due to the time value of money which dictates that a dollar today is worth more than a dollar at the end of the year. This concept is, however; captured through the adjustment of the different streams of cash flows using the cost of capital as a measure of the future cash flows to the present values, the base at which you can compare the different streams of cash flows. The cost of capital or the opportunity cost is usually estimated on the basis of economic trend at a particular period of time. The “Discounted Cash Flows, DCF” takes into account both the overall profitability of the project and also the timings of the returns. The timing of cash flows is taken into account by means of discounting. In discounted cash flows method the present value of future cash flows is calculated at different discount rates. The “Internal Rate of Return, IRR” and the “Net Present Value, NPV” are some of the techniques of investment appraisal that use the discounted cash flows. The rules that are used in the evaluation of property investment proposals measure economic worth of the investment. The inherent quality of a sound technique is to maximize the owner’s welfare. To be able to ascertain on whether to accept the proposal an investor in property needs to select a particular technique to evaluate the risk and profitability of the project, that is, to ascertain whether the property is a good investment opportunity or not (Rosen, 1974). “INTERNAL RATE OF RETURN”, IRR The IRR is the discounting factor (rate) that connects the present value (PV) of incoming cash with the original investment related to the property. That is, it is the rate at which “Net Present Value” of a property investment is equal to zero (0). Mathematically the IRR is found by the use of interpolation technique. In this case, 2 net present-values (NPV) are calculated both as close as possible to zero (0). This will result in one NPV being positive and the other being negative. After this is done the following formula is applied to solve for the IRR (Tabuchi, 1996). IRR = A + {(P/P+N) * (B-A)} Where; A = the lower rate of return with a positive NPV B = the higher rate of return with a negative NPV P = the amount of the positive NPV N = the amount of the negative NPV The decision criterion based on IRR The decision criterion when the IRR is used in making accept or reject decision relating to investment in property is as follows: If IRR > the cost of capital – invest in the property If IRR = cost of capital – the investor should consider other factors before investing in the property. If IRR < the cost of capital – you should not invest in the property. These criteria guarantee that the investment earns at least its required returns. This kind of outcomes should boost the market-value of property hence the creation of wealth for a property investor. Based on this technique therefore, 222 Wyndham Street, Alexandria property is not a viable project since its IRR is less than the cost of capital- (-12% < 7.2%) “NET PRESENT VALUE”, NPV The NPV of a cash outflow (investment) and cash inflows in the future years are calculated. The discount rate (opportunity cost or cost of capital) refers to the minimum returns that must be earned on a property investment in order to leave the property market value unchanged. The NPV is found by deducting the original investment (or PV of cash outflows) from the PV of the “cash inflows” after discounting at a rate equivalent to the “cost of capital”. Note that using the NPV both the inflows of cash and cash outflows are calculated in PV amounts. NPV = PV of Cash Inflows – PV of Cash Outflows Decision criterion The investment decision criterion when NPV is used to make accept or reject property investment decision is as follows: If NPV > 0 – invest in the property If NPV = 0 - the investor should consider other factors before investing in the property If NPV < 0 – you should not invest in the property JUSTIFICATION A positive NPV (NPV > 0) imply that the property generates returns that is capable of recovering the initial cost of the property, the operating expenses of a property investment and a surplus that is available for the owner of the property. This enhances the wealth of the owner of the property as it will earn a greater return than its cost of capital. A zero NPV means the funds generated is by the investment in the property is only capable of recovering the initial cost and meeting the operating expenses. When NPV < 0 (negative) it means the funds generated by the property cannot even recover the initial cost. Based on this analysis 222 Wyndham Street, Alexandria property is not a viable project since its NPV is less than zero (0) - negative NPV. That is, ($136,406) < 0. The impacts of leverage, risk and tax in property investment analysis LEVERAGE This is where the investor has borrowed fixed charge capital in order to finance his property investment. In this case therefore, there will be an obligation for the owner to pay (cash outflow) fixed interest amount for the borrowed amount. A better leverage results in high IRR and NPV. This is mainly because of the fact that interest on the borrowed amount is an expense that is first charged on the operating income before tax deductions and therefore it essentially reduces the tax burden on the income generating property. RISK A rise in the level of risk means that the discounting rate has risen. This is due to the fact that the chances of not realizing the expected returns from the property investment are high. When the level of risk is high keeping other factors constant it will not be wise to invest in such a project and the best decision is to reject it. Otherwise the expected return should be high enough to guarantee such an investment. This is guided by the general concept in investment: “the higher the risk the higher the returns”. TAX Tax is an expense to an income generating property and is charged against the net operating income. The effect is reduction in NPV of a property investment. The higher the tax, the lower the after- tax income (Domain, 2011). RECOMMENDATION The report recommends a further improvement the use of more loan amount to finance the investment in 222 Wyndham Street, Alexandria property as this increment will achieve a better leverage and hence a high NPV and IRR. It is also recommended that there should be some tax incentives to reduce the tax burden on the property investment. This will enable the income generating property to realize some positive returns from the investment. The report recommends the use of flexible loan amount that declines the interest payment, which is the interest payment, should not be fixed but rather should be based on the net loan amount that is remaining to be unpaid. CONCLUSION Investment in 222 Wyndham Street, Alexandria property should be financed more through the debt financing and partly through personal savings. This creates a better leverage and hence positive returns from the investment. The NPV of 222 Wyndham Street, Alexandria investment is less than zero and therefore the investor should not consider this project for investment purposes (St. George, 2011). Its IRR is also less than the cost of capital and therefore, the investment should be rejected. Based on these techniques of property investment appraisal 222 Wyndham Street, Alexandria property is not a viable investment. The project can however be better improved for investment purposes if some standings in relation to leverage, risk and tax changed since they greatly impact on a property investment. REFERENCES Carao, R., Hernandez, A. (1992). ‘Determinants of Urban Residential Land Values: Makati’, Quezon City: University of the Philippines. Domain, (2011) Property Research Report for 2015, retrieved 2nd June, 2011 Rosen, S. (1974), “Hedonic Prices and Implicit Markets: Product Differentiation in Pure Competition”, The Journal of Political Economy, 82(1): 34 – 55. St. George, (2011) Tools Calculators and FAQs, retrieved 2nd June, 2011, Tabuchi, T. (1996),”Quantity Premia in Real Property Markets’, Land Economics, 72(2): 206 – 217. Read More