Quiz 12: Financial Leverage and Financing Alternatives

Business

An investor would like to purchase a new apartment property for $2 million. However, she faces the decision of whether to use 70 percent or 80 percent financing. The 70 percent loan can be obtained at 10 percent interest for 25 years. The 80 percent loan can be obtained at 11 percent interest for 25 years. NOI is expected to be $190,000 per year and increase at 3 percent annually, the same rate at which the property is expected to increase in value. The building and improvements represent 80 percent of value and will be depreciated over 27.5 years ( per year). The project is expected to be sold after five years. Assume a 36 percent tax bracket for all income and capital gains taxes. a. What would the BTIRR and ATIRR be at each level of financing (assume monthly mortgage amortization) b. What is the break-even interest rate (BEIR) for this project c. What is the marginal cost of the 80 percent loan What does this mean d. Does each loan offer favorable financial leverage Which would you recommend

Free

Essay

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.

Q 2

What is financial leverage Why is a one-year measure of return on investment inadequate in determining whether positive or negative financial leverage exists

Free

Essay

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.

Q 3

You are advising a group of investors who are considering the purchase of a shopping center complex. They would like to finance 75 percent of the purchase price. A loan has been offered to them on the following terms: The contract interest rate is 10 percent and will be amortized with monthly payments over 25 years. The loan also will have an equity participation of 40 percent of the cash flow after debt service. The loan has a "lockout" provision that prevents it from being prepaid before year 5. The property is expected to cost $5 million. NOI is estimated to be $475,000, including overages, during the first year, and to increase at the rate of 3 percent per year for the next five years. The property is expected to be worth $6 million at the end of five years. The improvement represents 80 percent of cost, and depreciation will be over 39 years. Assume a 28 percent tax bracket for all income and capital gains and a holding period of five years. a. Compute the BTIRR and ATIRR after five years, taking into account the equity participation. b. What would the BEIR be on such a project What is the projected cost of the equity participation financing c. Is there favorable leverage with the proposed loan

Free

Essay

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.

Q 4

What is the break-even mortgage interest rate (BEIR) in the context of financial leverage Would you ever expect an investor to pay a break-even interest rate when financing a property Why or why not

Essay

Q 5

A developer wants to finance a project costing $1.5 million with a 70 percent, 25-year loan at an interest rate of 8 percent. The project's NOI is expected to be $120,000 during year 1 and the NOI , as well as its value, is expected to increase at an annual rate of 3 percent thereafter. The lender will require an initial debt coverage ratio of at least 1.20. a. Would the lender be likely to make the loan to the developer Support your answer with a cash flow statement for a five-year period. What would be the developer's before-tax yield on equity ( BTIRR ) b. Based on the projection in ( a ), what would be the maximum loan amount that the lender would make if the debt coverage ratio was 1.15 for year 1 What would be the loan-to-value ratio c. Assuming conditions in part ( a ), suppose that mortgage interest rates suddenly increase from 8 percent to 10 percent. NOI and value will now increase at a rate of 5 percent. If the desired DCR is 1.20, will the lender be as willing to make a conventional loan now Support your answer with a cash flow statement.

Essay

Q 6

What is positive and negative financial leverage How are returns or losses magnified as the degree of leverage increases How does leverage on a before-tax basis differ from leverage on an after-tax basis

Essay

Q 7

Ace Development Company is trying to structure a loan with the First National Bank. Ace would like to purchase a property for $2.5 million. The property is projected to produce a first year NOI of $200,000. The lender will allow only up to an 80 percent loan on the property and requires a DCR in the first year of at least 1.25. All loan payments are to be made monthly, but will increase by 10 percent at the beginning of each year for five years. The contract rate of interest on the loan is 12 percent. The lender is willing to allow the loan to negatively amortize; however, the loan will mature at the end of the five-year period. a. What will the balloon payment be at the end of the fifth year b. If the property value does not change, what will the loan-to-value ratio be at the end of the five-year period

Essay

Q 8

In what way does leverage increase the riskiness of a loan

Essay

Q 9

An institutional lender is willing to make a loan for $1 million on an office building at a 10 percent interest (accrual) rate with payments calculated using an 8 percent pay rate and a 30-year loan term. (That is, payments are calculated as if the interest rate were 8 percent with monthly payments over 30 years.) After the first five years the payments are to be adjusted so that the loan can be amortized over the remaining 25-year term. a. What is the initial payment b. How much interest will accrue during the first year c. What will the balance be after five years d. What will the monthly payments be starting in year 6

Essay

Q 10

What is meant by a participation loan What does the lender participate in Why would a lender want to make a participation loan Why would an investor want to obtain a participation loan

Essay

Q 11

A property is expected to have NOI of $100,000 the first year. The NOI is expected to increase by 3 percent per year thereafter. The appraised value of the property is currently $1 million and the lender is willing to make a $900,000 participation loan with a contract interest rate of 8 percent. The loan will be amortized with monthly payments over a 20-year term. In addition to the regular mortgage payments, the lender will receive 50 percent of the NOI in excess of $100,000 each year until the loan is repaid. The lender also will receive 50 percent of any increase in the value of the property. The loan includes a substantial prepayment penalty for repayment before year 5, and the balance of the loan is due in year 10. (If the property has not been sold, the participation will be based on the appraised value of the property.) Assume that the appraiser would estimate the value in year 10 by dividing the NOI for year 11 by a 10 percent capitalization rate. Calculate the effective cost (to the borrower) of the participation loan assuming the loan is held for 10 years. (Note that this is also the expected return to the lender.)

Essay

Q 12

What is meant by a sale-leaseback Why would a building investor want to do a sale-leaseback of the land What is the benefit to the party that purchases the land under a sale-leaseback

Essay

Q 13

Refer to problem 6. Assume that another alternative is a convertible mortgage (instead of a participation loan) that gives the lender the option to convert the mortgage balance into a 60 percent equity position at the end of year 10. That is, instead of receiving the payoff on the mortgage, the lender would own 60 percent of the property. The loan would be for $900,000 with a contract rate of 9 percent, and it would be amortized over 20 years. Assume that the borrower will default if the property value is less than the loan balance in year 10. a. What is the lender's IRR if the property sells for the same price in year 10 as the previous example b. What is the lender's IRR if the property sells for only $1 million after 10 years c. What is the lender's IRR if the property sells for only $500,000 after 10 years (Reference Problem 6) A property is expected to have NOI of $100,000 the first year. The NOI is expected to increase by 3 percent per year thereafter. The appraised value of the property is currently $1 million and the lender is willing to make a $900,000 participation loan with a contract interest rate of 8 percent. The loan will be amortized with monthly payments over a 20-year term. In addition to the regular mortgage payments, the lender will receive 50 percent of the NOI in excess of $100,000 each year until the loan is repaid. The lender also will receive 50 percent of any increase in the value of the property. The loan includes a substantial prepayment penalty for repayment before year 5, and the balance of the loan is due in year 10. (If the property has not been sold, the participation will be based on the appraised value of the property.) Assume that the appraiser would estimate the value in year 10 by dividing the NOI for year 11 by a 10 percent capitalization rate. Calculate the effective cost (to the borrower) of the participation loan assuming the loan is held for 10 years. (Note that this is also the expected return to the lender.)

Essay

Q 14

Why might an investor prefer a loan with a lower interest rate and a participation

Essay

Q 15

A borrower and lender negotiate a $20,000,000 interest-only loan at a 9 percent interest rate for a term of 15 years. There is a lockout period of 10 years. Should the borrower choose to prepay this loan at any time after the end of the 10th year, a yield maintenance fee ( YMF ) will be charged. The YMF will be calculated as follows: A treasury security with a maturity equal to the number of months remaining on the loan will be selected, to which a spread of 150 basis points (1.50 percent) will be added to determine the lender's reinvestment rate. The penalty will be determined as the present value of the difference between the original loan rate and the lender's reinvestment rate. a. How much will the YMF be if the loan is repaid at the end of year 13 if 2-year treasury rates are 6 percent What if two-year treasury rates are 8 percent

Essay

Q 16

Why might a lender prefer a loan with a lower interest rate and a participation

Essay

Q 17

Excel. Refer to the participation loan example in the chapter. Suppose the participation was reduced to 25 percent of the NOI in excess of $100,000 but increased to 75 percent of the gain in value. a. What is the investor's before- and after-tax IRR b. What is the lender's IRR

Essay