Quiz 12: Financial Leverage and Financing Alternatives

Business

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 img year: Value of property after five years can be calculated with the help of growth rate. Value of apartment is img , apartment is sold after img year, and growth rate is img . Write the expression to calculate the value of property. img Here, img is the current value of property, img is the growth rate, and img is the number of year. Substitute img for img , img for img , and img for img . img Hence, the value of property after img year is img . Interest per annum when loan is img financing: Interest paid per annum can be calculated with the help of interest rate and proportion of loan. Proportion of loan is img , and interest on loan is img . Write the expression to calculate the interest per annum. img Substitute img for value of property, img for proportion of loan, and img for interest rate. img Hence, the interest per annum is img . 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 img , and expected growth rate for net operating income is img . Calculation of IRR is given in below excel. img The resultant figure from the excel sheet is given below. img Hence, the before tax internal rate of return (BTIRR) is img . 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. img The resultant figure from the excel sheet is given below. img Hence, the after-tax internal rate of return (ATIRR) is img . Interest per annum when loan is img financing: Interest paid per annum can be calculated with the help of interest rate and proportion of loan. Proportion of loan is img , and interest on loan is img . Write the expression to calculate the interest per annum. img Substitute img for value of property, img for proportion of loan, and img for interest rate. img Hence, the interest per annum is img . 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 img , and expected growth rate for net operating income is img . Calculation of IRR is given in below excel. img The resultant figure from the excel sheet is given below. img Hence, the before tax internal rate of return is img . 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. img The resultant figure from the excel sheet is given below. img Hence, the after-tax internal rate of return is img . 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: img Hence, the break-even interest rate is img . Break even interest rate in case of 80% loan is calculated below: img Hence, the break-even interest rate is img . 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 img loan: Marginal cost can be computed with the help of interest rate charges on both loans. Write the expression to calculate the marginal cost. img Substitute img for interest rate on img loan, and img for interest rate on img loan. img Hence, the marginal cost for img loan is img . 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 img loan financing, investor will get img before tax internal rate of return and if investor selects img loan financing then the investor will get img before tax internal rate of return. And if, investor selects the img loan financing, investor will get img after tax internal rate of return and if investor selects img loan financing then investor will get img after tax internal rate of return. Hence, the only loan that offers favorable financial leverage is img 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: img 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%. img img Calculate the cash flow after participation. img Calculate the ATCF after participation. img img Calculate the before tax cash from sales in year 5. img Calculate the after tax cash flow from sales in year 5. img img img Calculate the before tax cash flow internal rate of return (BTIRR). img Using RATE function in excel spread sheet calculate the IRR for the before tax cash flows. img Therefore, the BTIRR on equity is 17.98%. Calculate the after tax cash flow internal rate of return (ATIRR). img Using RATE function in excel spread sheet calculate the IRR for the after tax cash flows. img 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% img Calculate the before tax and after-tax cash flows. img img img Calculate the before tax cash flow from sales in year 5. img Calculate the after tax cash flow from sales in year 5. img 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. img Using RATE function in excel spread sheet calculate the IRR for the before tax cash flows. img Therefore, the BTIRR on equity is 13.09%. Calculate the ATIRR. img Using RATE function in excel spread sheet calculate the IRR for the after tax cash flows. img Therefore, the IRR for the after-tax cash flows is 9.70%. Now, calculate the break-even interest rate. img Hence, the break-even interest rate is 13.47%. Calculate the projected cost of participation. img 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. img Therefore, the projected cost of equity participation financing is 10.95%. c. img Therefore, there is a favourable leverage. The IRR increases on both before and after tax basis.

Related Quizzes