(15 pts) Explain in your own words what is “the NPV Investment Decision Rule”, and why it makes sense, what it is
The NPV Decision Rule says: “Maximize the NPV across all mutually exclusive available and feasible
investment alternatives, and never make an investment with NPV < 0.”
The NPV is the present value of the investment benefit (or gross asset value) minus the present value of the
cost or price of making the investment: NPV = B – C, or = V – P, where the benefits (V) and the costs (P)
are measured in equivalent risk-adjusted (certainty-equivalent) present value money.
This investment decision rule makes sense because it is based on the “Wealth Maximization” criterion. If
the investor wants to maximize his/her wealth, he/she must apply the NPV Decision Rule. Any other rule
not consistent with the NPV rule would “leave money on the table”, that is, reduce the investor’s net wealth
value compared to using the NPV rule.
3. (10 pts) What is the difference between a property’s Net Operating Income (NOI) and its Property Before-Tax Cash
The difference is capital improvement expenditures: PBTCF = NOI – CI.
4. (20 pts) Suppose a property can be bought for $1,000,000 and it will provide $100,000/year net cash flow forever, and
you can borrow a perpetual interest-only mortgage secured by that property at an 8% interest rate, up to an amount of
$750,000. (a) Does this present “positive” or “negative leverage”, and (b) why? (c) Will the expected return to the levered
equity be less than 8%, exactly 8%, between 8% and 10%,
exactly 10%, or greater than 10%? (d) Do you think that the use
of leverage in this case will increase the NPV of the investment for the equity investor in the property? (e) Why or why
(a) Positive Leverage;
(b) Because the expected return on the property (10%) exceeds that on the loan (8%).
(c) Greater than 10%, due to the effect of the above-noted “positive leverage”.
(e) because there is no reason to think that the 8% loan is subsidized, and no mention of investor’s tax rate, so we
must be considering MV (not IV), and therefore borrowing should be NPV=0.
5. (10 pts) Do you think in general (or typically on average) the going-in cap rate is larger or smaller than the going-out or
terminal cap rate? Why?
In general (typically on average) the going-in cap rate should be at least a little lower than the going-out cap rate,
due to the aging of the property, and hence its typically becoming a little more risky, or moving from a more
“institutional quality” property toward a more “non-institutional quality” property.
A certain housing development has the following projected equity net cash flows per year (in thousands):
Project net cash flows
There are to be two classes of investors providing the equity capital. A preferred investor is committed to provide $6
million with a 10% preferred return (computed on a current basis, accumulated with compounding). The subordinated (or