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chapter020 - CHAPTER 20 Investment Decisions NPV and IRR...

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CHAPTER 20 Investment Decisions: NPV and IRR Test Questions 1. A real estate investment is available at an initial cash outlay of $10,000, and is expected to yield cash flows of $3,343.81 per year for five years. The internal rate of return (IRR) is approximately: b. 20 percent. 2. The net present value of an acquisition is equal to: b. the present value of expected future cash flows, less the initial cash outlay. 3. Present value: b. is the value now of all net benefits that are expected to be received in the future. 4. The internal rate of return equation incorporates: d. initial cash outflow and inflow, and future cash outflow and inflow. 5. The purchase price that will yield an investor the lowest acceptable rate of return: a. is the property’s investment value to that investor. 6. What term best describes the maximum price a buyer is willing to pay for a property? a. investment value 7. An income-producing property is priced at $600,000 and is expected to generate the following after-tax cash flows: Year 1: $42,000; Year 2: $44,000; Year 3: $45,000; Year 4: $50,000; and Year 5: $650,000. Would an investor with a required after-tax rate of return of 15 percent be wise to invest at the current price? b. No, the NPV is -$148,867. 8. As a general rule, using financial leverage: b. increases risk to the equity investor. 9. What is the IRR, assuming an industrial building can be purchased for $250,000 and is expected to yield cash flows of $18,000 for each of the next five years and be sold at the end of the fifth year for $280,000? c. 9.20 percent 20-1
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10. Given the following information, what is the required equity investment due at closing? • Acquisition price: $800,000 • Loan-to-value ratio: 75% • Financing cost: 3% c. $218,000 Study Questions 1. List three important ways in which DCF valuation models differ from direct capitalization models. Solution : Direct capitalization models require an estimate of stabilized income for one year. DCF models require estimates of net cash flows over the entire expected holding period. In addition, the cash flow forecast must include the net cash flow expected to be produced by the sale of the property at the end of the expected holding period. Finally, the appraiser must select the appropriate yield (required IRR) at which to discount all future cash flows or to use as the hurdle rate in an IRR analysis. 2. Why might a commercial real estate investor borrow to help finance an investment even if she could afford to pay 100 percent cash? Solution : Borrowing--i.e., the use of “other people’s money”—is also refereed to as the use of financial leverage. If the overall return on the property exceeds the cost of debt, the use of leverage can significantly increase the rate of return investors earn on their invested equity. This expected magnification of return often induces investors to partially debt finance even if they have the accumulated wealth to pay all cash for the property. Other potential benefits of leverage
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