# Quiz 12: Financial Leverage and Financing Alternatives

Net operating income: It reflects the profitability of real estate investment. It examines the cash flow of investment property before the factors such as taxes and finance costs. The difference between all the operating expenses and the revenue generated by particular property is estimated as the Net Operating Income. a. Value of property after year: Value of property after five years can be calculated with the help of growth rate. Value of apartment is , apartment is sold after year, and growth rate is . Write the expression to calculate the value of property. Here, is the current value of property, is the growth rate, and is the number of year. Substitute for , for , and for . Hence, the value of property after year is . Interest per annum when loan is financing: Interest paid per annum can be calculated with the help of interest rate and proportion of loan. Proportion of loan is , and interest on loan is . Write the expression to calculate the interest per annum. Substitute for value of property, for proportion of loan, and for interest rate. Hence, the interest per annum is . Computation of before tax internal rate of return: Before tax internal rate of return can be computed with the help of net cash flows at each year. Expected net operating income in first year is , and expected growth rate for net operating income is . Calculation of IRR is given in below excel. The resultant figure from the excel sheet is given below. Hence, the before tax internal rate of return (BTIRR) is . Computation of after-tax internal rate of return: After tax internal rate of return can be computed with the help of net cash flows at each year. Calculation of IRR is given in below excel. The resultant figure from the excel sheet is given below. Hence, the after-tax internal rate of return (ATIRR) is . Interest per annum when loan is financing: Interest paid per annum can be calculated with the help of interest rate and proportion of loan. Proportion of loan is , and interest on loan is . Write the expression to calculate the interest per annum. Substitute for value of property, for proportion of loan, and for interest rate. Hence, the interest per annum is . Computation of before tax internal rate of return: Before tax internal rate of return can be computed with the help of net cash flows at each year. Expected net operating income in first year is , and expected growth rate for net operating income is . Calculation of IRR is given in below excel. The resultant figure from the excel sheet is given below. Hence, the before tax internal rate of return is . Computation of after-tax internal rate of return: After tax internal rate of return can be computed with the help of net cash flows at each year. Calculation of IRR is given in below excel. The resultant figure from the excel sheet is given below. Hence, the after-tax internal rate of return is . b. Break even interest rate: Break-even mortgage rate refers to that rate at which financial leverage does not fetch any benefit to the investor. The rise of the mortgage rate above the break-even mortgage rate causes financial leverage to fetch negative returns. On the other hand, if mortgage rate falls below the break-even mortgage rate, then financial leverage will fetch positive returns. Break even interest rate is the rate is calculated by after tax IRR divided by one minus tax rate. Break even interest rate in case of 70% loan is calculated below: Hence, the break-even interest rate is . Break even interest rate in case of 80% loan is calculated below: Hence, the break-even interest rate is . c. Marginal cost: The increase or decrease in the collective cost of a production run for making one extra unit of a thing. It is registered in circumstances where the breakeven point has been achieved. The fixed expenses have just been consumed by the units already produced and the variable costs must be represented. Marginal cost for loan: Marginal cost can be computed with the help of interest rate charges on both loans. Write the expression to calculate the marginal cost. Substitute for interest rate on loan, and for interest rate on loan. Hence, the marginal cost for loan is . d. Financial Leverage: The benefit that an investor receives from the use of debt is known as financial leverage. Benefit from use of financial leverage arises when rate of interest paid by the investor on the borrowed amount is lower than the rate of return received from the investment. The return on the equity of the investor is enlarged by the use of financial leverage. Whether each loan offers favorable financial leverage: When investor selects the loan financing, investor will get before tax internal rate of return and if investor selects loan financing then the investor will get before tax internal rate of return. And if, investor selects the loan financing, investor will get after tax internal rate of return and if investor selects loan financing then investor will get after tax internal rate of return. Hence, the only loan that offers favorable financial leverage is loan.

Capitalization Rate: The rate of return that a real estate property is expectedto generate on the basis of its expected income is known as capitalization rate. It is used by the investors to compare the earning potential of different real estate properties. It is computed by dividing the net operating income by current and acquisition cost of the real estate property. Financial leverage: The benefit that an investor receives from the use of debt is known as financial leverage. Benefit from use of financial leverage arises when interest rate paid by the investor on the borrowed amount is lower than the rate of return received from the investment.The use of financial leverage magnifies the return on the equity of the investor. Hence,benefit that results from the use of debt is known as financial leverage. The reason because of which one-year measure of return on investment inadequate in determining whether positive or negative financial leverage exists: When internal rate of return of the project is more than the rate of interest of the fund borrowed, then financial leverage is positive otherwise not. A measure based on one-year measure such as capitalization rate is not adequate. It is because the one year measure of return on investment does not consider future income or loss.

Internal rate of return (IRR), a technique used in capital budgeting that makes the net present value of cash flows equal to zero. Before tax internal rate of return (BTIRR) is the rate of return on the cash flows before interest and taxes. After tax internal rate of return (ATIRR) is the rate of return on the cash flows after deducting the interest and taxes. Consider the following data: Following are the tax considerations: The building with a value of 400,000 is depreciated for 39 years and has a tax rate of 28%. Calculate the cash flow after participation. Calculate the ATCF after participation. Calculate the before tax cash from sales in year 5. Calculate the after tax cash flow from sales in year 5. Calculate the before tax cash flow internal rate of return (BTIRR). Using RATE function in excel spread sheet calculate the IRR for the before tax cash flows. Therefore, the BTIRR on equity is 17.98%. Calculate the after tax cash flow internal rate of return (ATIRR). Using RATE function in excel spread sheet calculate the IRR for the after tax cash flows. Therefore, the IRR for the after-tax cash flows is 14.11%. b. Calculate the breakeven interest rate (BEIR). First calculate the ATIRR when there is no financing. Here, Loan-to-value ratio changes from 75.00% to 0% Equity percentage changes from 40% of BTCF to 0% Calculate the before tax and after-tax cash flows. Calculate the before tax cash flow from sales in year 5. Calculate the after tax cash flow from sales in year 5. Particulars Amount Sales price 6000000 Sales costs 0 Participation 0 Original cost 5000000 Less: Accumulated depreciation 512820 Adjusted basis value 4487180 Capital gain (6000000-4487180) 1512820 Tax from sales (1512820×0.28) 423590 After tax cash flow from sales (6000000-423590) 5576410 Calculate the BTIRR. Using RATE function in excel spread sheet calculate the IRR for the before tax cash flows. Therefore, the BTIRR on equity is 13.09%. Calculate the ATIRR. Using RATE function in excel spread sheet calculate the IRR for the after tax cash flows. Therefore, the IRR for the after-tax cash flows is 9.70%. Now, calculate the break-even interest rate. Hence, the break-even interest rate is 13.47%. Calculate the projected cost of participation. Cost of participation Year Debt service Loan balance Participation Loan amount Cash flow to lender 0 408915 -3750000 -3750000 1 408915 26434 435349 2 408915 32134 441049 3 408915 38005 446920 4 408915 44052 452967 5 408915 3531141 50281 3990337 Calculate the IRR on the loan using IRR function in excel sheet. Therefore, the projected cost of equity participation financing is 10.95%. c. Therefore, there is a favourable leverage. The IRR increases on both before and after tax basis.