Lesson10_Investment

6m 20000 in taxes net present value 19660 invest hit

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Unformatted text preview: (Invest) Hit [IRR], [CPT] Dr. Eriksen Lesson 10: RE Investment 10 11 th 12 4 Real Estate Fundamentals Texas Tech University NPV v. IRR IRR implicitly treats cash flows as if reinvested at a return equal to IRR rather than investor’s opportunity cost (required yield each period) IRR can rank investment opportunities differently than NPV (NPV = max Wealth) If projected cash flows change signs more than once, IRR may have multiple true solutions NPV is therefore usually preferred over IRR You still usually calculate both or use Modified IRR HOW MUCH DEBT? Reasons for use of debt by investors: Limited financial resources Ability to “magnify” or “leverage” equity returns. Increased leverage will increase the estimated NPV when…. Opportunity cost of equity capital (discount rate) exceeds the effective borrowing cost Leverage increases variability of equity returns Potentially Exposing Yourself to Default HOW MUCH DEBT? Three Main Uses of Debt Limited financial resources To permit portfolio diversification Debt amplifies returns to equity (and risk) Cash flow effect of borrowing: Net operating income Debt service_____________ = Before tax cash flow (BTCF) Also need to consider repayment of principal on property’s disposition (equity reversion) Dr. Eriksen Lesson 10: RE Investment 13 14 15 5 Real Estate Fundamentals Texas Tech University Debt Example Bill Gates Recently Purchased a $2m house and is deciding if he should take out a loan. He has been offered a $1m 5 year interest only mortgage at 5.4% with no origination fees He will sell his house for $2.8 million in 5 years and his monthly discount rate is 0.5% What is his IRR without a Loan? N = 60, PV = 2m, Pmt = 0, FV = 2.8m, i = 0.56 What is his IRR with a Loan? Debt Example (Continued) Three Things to Consider Initial Investment: $1 million Monthly Payments: $1m x (0.054/12) = $4,500 Before Tax Equity Reversion (BTER) Before Tax Equity Reversion (BTER) Don’t Forget He Has to Pay Back Loan Principal $2.8m $1m = $1.8m net loan proceed...
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