1. (15 pts) Explain in your own words what is “the NPV Investment Decision Rule”, and why it makes sense, what it is based on.
* 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 Flow (PBTCF)?
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 not?
(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”.