NPV Analysis

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The NPV spreadsheets are the part of this document.

Sheikh Saeed

STRATEGIC FINANCIAL MANAGEMENT

MBA 1 A

ASSIGNMENT

PRESENTED TO:

DR. GERALD POLLIO

19 AUGUST 2009

LONDON SCHOOL OF COMMERCE

NPV Analysis.xls


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Table of Contents

QUESTIO 1:............................................................................................................................................... 1

PRESENT VALUE CALCULATION .................................................................................................................1

Explanation:.......................................................................................................................................... 1

QUESTIO 2 ................................................................................................................................................ 3

QUESTIO 3:............................................................................................................................................... 3

PART 1: FIACIAL AALYSIS.....................................................................................................4

PV METHOD...................................................................................................................................... 4

IRR of the Differential...........................................................................................................................5

Discount Rate Sensitivity....................................................................................................................... 6

Why to rely on PV and IRR?...............................................................................................................7

CONCLUSION: .............................................................................................................................................8

PART 2: CRITICAL ISSUES..............................................................................................................9

CAPITAL RATIONING................................................................................................................................... 9

Hard Capital Rationing.........................................................................................................................9

Soft Capital Rationing:.......................................................................................................................... 9

LEASE VERSUS BUYING ..............................................................................................................................9

Operating Lease.................................................................................................................................. 10

Financial Lease ................................................................................................................................... 10

REAL ESTATE SPECIFIC ISSUES .................................................................................................................. 10

Leasing/Renting a Real estate ............................................................................................................. 10

Purchasing a Real estate..................................................................................................................... 11

Benefit of choosing Leasing (Option 3)............. ........... ........... .......... ........... .......... .......... ........... ........ 12

WACC AND LEVERAGE............................................................................................................................ 13

WACC (Weighted Average Cost of Capital)............... ......... ........... .......... ........... .......... .......... ........... . 13

Leverage.............................................................................................................................................. 14

The Effect of Financial Leverage ........................................................................................................ 14

INFLATION ................................................................................................................................................ 15

REFERECES............................................................................................................................................ 16


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FIGURE 2

Option 1: PV of Purchase without Finance

0 Initial Capital Investment + PV of Purcha se wit hout Finance

1 Relevant Benefits (Rental Savings)

9 + Residual ValueRelevant Benefits (Rental Savings)

Years from

Project

Launch

FIGURE 3

FIGURE 4


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Question 2

Net Present Value (NPV) is the difference between present values of cash INFLOWS andPresent values of cash OUTFLOWS of an investment or project. Or;

NPV = Present values of all Cash Flows Initial InvestmentOr

Where, C is the cash flow at future time t, discounted at the opportunity cost of r.relevant cost and benefits of the project must also be included in calculating PV of cashflows.

The NPV for the project option 1, 2 & 3 are calculated below using Figure 1, 3 & 4.

FIGURE 5

Question 3:

The answer to the cost effectiveness of the projects of mutually exclusive nature lies in athoughtful assessment of numerous subjective questions and a thorough objectiveanalysis of the cash flows of the option available. In our cost analysis we are assessingthree possibilities of acquiring a building for business use. The options are financing project with equity, part-financing with 30% equity and 70% through borrowing andlease renting the building.

The decision to own, part-finance or lease is often driven by the cash and space needs ofthe business; whether the space is retail, office, industrial, mixed use, or special use; the


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importance of branding, protecting, or creating trade areas; establishing franchise value;or other circumstances.

Comparison of cost effectiveness of real estate projects requires evaluation of eachalternative on the basis of financial outcomes as well as its advantages and disadvantagesattributed due to the nature of use. The first part of our cost efficiency analysis will bebased on financial examination to evaluate the cost effectiveness of project alternatives(option 1 to 3). Second part will focus on the other issues particularly associated withowning and leasing building for business use.

PART 1: Financial Analysis

The two methods of comparing project cost effectiveness are the net present value (NPV)method and the internal rate of return (IRR) method. IRR measures the profitability of theproject. It is an internal rate of return in the sense that it depends only on the projectsown cash flows. The opportunity cost of capital is the standard for deciding whether toaccept the project. It is equal to the return offered by equivalent-risk investments in thecapital market. As IRR method is considered to be less reliable for investment decision,its use in incremental cash flow analysis is somewhat recommended to further strengthenthe decision based on NPV method. The IRR of the differential of mutually exclusiveprojects allow us to compare them with respect to inherent initial investment disparitiesamong them. (Brealey et al; 2006)

PV METHOD

The NPV method compares the present values of the cash flows of project alternativesdiscounting them back at the opportunity cost (discount rate) of the firm. NPV is ameasure of how much value is created or added today by undertaking an investment oflong term nature. Given the goal of creating value for the stockholders, the capital budgeting process can be viewed as a search for investments with positive net presentvalues. (Brealey et al; 2006)

The NPV rule for project appraisal is that any project with positive NPV is worth

investment. However in case under consideration, where most cost effective alternative isrequired to be indentified, the project alternative with highest NPV will be consideredworth investment.

When a choice has to be made between alternative projects which are mutually exclusive,it should be based on the size of the NPV either the highest NPV surplus, or the leastNPV deficit, as appropriate. (Mott, 2005; page 222)

NPV of each project option, as calculated in Question 2 is as follow.


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FIGURE 6

The most cost effective option is leasing the building, as it returns the highest NPV of($3,930,859.00). This means that leasing the building will incur least cash out flow (withrespect to opportunity cost of the firm) during its life as compare to other two options.

Purchasing (option 1) will result in total discounted cash inflows (including relevant benefits) of about $5.5 millions, However, considering the initial investment of $ 11.4millions, projects cash inflows are about $5.9 millions less than the initial capital

investment. (Figure 1) Therefore it is not worth investing under NPV analysis.

Part-Financing (option 2) appears to be very close to Lease option, but in this scenario,even after an investment of $3.58 millions results in negative net cash flow of $0.56millions. (Figure 3) However, this option will be further evaluated in IRR analysis.

Leasing (option 3) shows highest cash flows from project, although a negative figure.Therefore the firm should lease the building instead of owning or part financing it.(Figure 4)

IRR of the Differential

Purpose: to evaluate whether purchase or part-finance is worth investing as compare tolease.

When analyzing two investments, one more expensive than the other, the internal rate ofreturn on the difference in their cash flows measures the extra potential return of the moreexpensive investment. (Brealey et al; 2006) We know that internal rate of return is anestimate for the potential yield on an investment, however, by calculating theIncremental IRR (IRR of the differential) we evaluate whether the risk of increasedcapital investment is worth the potential reward. It is generally agreed that formutually exclusive projects, if the IRR of the differential is higher than the

minimum acceptable rate of return, the more expensive investment is considered the

better one. (Khan & Jain, 2007). Therefore we will analyse, whether the IRR of the

differential of leasing the building is higher than purchasing or part financing or not? If itis higher than, we conclude that LEASING the project is most cost efficient.

The IRR of the differential method subtracts the cash flow after tax of leasing from thecash flow after tax of purchasing options, to arrive at a differential cash flow on which aninternal rate of return can be calculated. This IRR is then compared to the opportunitycost of capital (discount rate) of the firm. In most cases, firms have a somewhat specificknowledge of the opportunity cost on their projects, therefore a caparison of two(opportunity cost and IRR of the differential) give insight into the project with significantdisparities in initial capital investment outlays. (Benninga & Czaczkes;)


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To the extent that the IRR of the differential cash flows (generated by owning thebuilding in option 1 and 2) is greater than the yield generated by the business, the firmwould select the purchase alternative. Conversely, if the yield is less than the yield that

firm can achieve on its business, the firm should select the lease option.

The following table shows IRR differential for all three options being considered. Thehighest IRR is between cash flow of option 2 minus 3, (i.e. the part finance minus lease)therefore option 3 should be selected as it will yield highest return.

FIGURE 8

IRR of the Differential

Differential Cash Flows After Tax ($)Discounted years 1 minus 3 2 minus 3 1 minus 2

0 -11,400,000 -3,579,000 -7,821,0001 730,949 156,383 574,566

2 740,300 154,975 585,325

3 740,300 149,820 590,480

4 740,300 144,237 596,063

5 740,300 138,191 602,109

6 806,300 197,643 608,657

7 806,300 190,551 615,749

8 806,300 182,871 623,429

9 12,676,374 5,902,412 6,773,962

IRR of the

Differential 7% 9% 6%

In discount rate sensitivity curves drawn in Figure 9, point (a) on the discount rate x-axisrepresent the IRR of the differential of Part-Finance and Lease, point (b) represents thePurchase and Lease, point (c) represents Part-Finance and Lease.

Discount Rate Sensitivity

It is important to look at a range of discount rates because the size and timing of the cashflows of the lease and purchase option vary at different rates. Particularly, the largestinequality in size and timing usually occurs in year zero because of the size of the initialinvestment, and in year 9 due to the positive cash flow generated through residual value;however, year zero cash flows are not discounted at all. In lease versus purchase analysis,the only positive cash flow comes in the form of residual value at year 9. As the discountrates increase they minimize the positive effect of the residual value, and thus, flatten thecurve in the purchase option (as shown in the figure.9)

In our case under consideration, if the firms opportunity cost was less than 6% [point (a)in Figure 9], then the purchase option 1 would have been most cost efficient for the firm.However, as the firms opportunity cost (discount rate) is 10%, the leasing is the lowestcost option with 9% IRR of the differential (option 3- option 2). In Figure 9 point (c)represent the discount rate of 9% which is IRR differential between options 2 minus 3.


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This is the reason the firms with low overhead and high margins tend to lease real estate,except when maintaining control and security are vitally important and often outweighthe financial assessments. The firms opportunity cost is 10%, which is very close to the

highest IRR of the differential of leasing (i.e. 9%), the firm would likely be indifferent toleasing or owning the building. To further strengthen our decision to choose most costeffective option, we will also examine the inherent advantages and disadvantages ofowing a building for business use and leasing it.

FIGURE 9

Discount Rate Sensitivity

-10,000,000

-8,000,000

-6,000,000

-4,000,000

-2,000,000

0

2,000,000

0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 16% 17%

Discount Rate

PV

Purchase

Purchase with Finance

Lease

Option (1) IRR Firms opportunity Cost

a b c

Why to rely on PV and IRR?

The Advantages is it will give the correct decision advice assuming a perfect capitalmarket, and correct ranking for mutually exclusive projects. It is easy to compare theNPV of different projects and to reject projects that do not have an acceptable NPV.On the other hand, NPV as method of investment appraisal requires the decision criteria

to be specified before the appraisal can be undertaken. It is very difficult to identify thecorrect discount rate.

Both NPV and IRR are referred to as discounted cash flow methods because they factorthe time value of money into the capital investment project evaluation. Both NPV andIRR are based on a series of future payments (negative cash flow), income (positive cashflow), losses (negative cash flow), or "no-gainers" (zero cash flow).

NPV determines whether a project earns more or less than a desired rate of return and isgood at finding out whether or not a project is going to be profitable. IRR goes one stepfurther than NPV to determine a specific rate of return for a project. Both NPV and IRR


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PART 2: Critical IssuesOther issues that could influence the decision to evaluate cost effectiveness of the projectunder review also need to be examined. These issues need careful consideration beforeany project appraisal is accepted, due to their impact on financial health of the business.As it is not possible to calculate some of the critical elements used in analysis of projectscost efficiency a brief theoretical discussion is necessary. Investment appraisal isconcerned with decisions about whether, when and how to spend money on capital projects. Such decisions are important ones for the companies involved because oftenlarge sums of money are committed in an irreversible decision, with no certainknowledge of the size of future benefits. (Mott, 2005)

Capital RationingWHY: We do not have enough information to evaluate the firms policy regarding availability of

capital resources.

A firm maximizes its wealth by accepting every project that has a positive net presentvalue. The act of placing restrictions on the amount of new investments or projectsundertaken by a company is called capital rationing. This is accomplished by imposing ahigher cost of capital for investment consideration or by setting a ceiling on the specificsections of the budget. (Mott, 2005, Brealey 2006) There are two types of capital

rationing.

Hard Capital Rationing

This arises when constraints are externally determined and the firm is unable to borrowfrom the outside. For example if the firm is under financial distress, tight creditconditions, firm has a new unproven product. Borrowing limits are imposed by banksparticularly in relation to smaller firms and individuals.

Soft Capital Rationing:

This is due to internal, management-imposed limits on investment expenditure. Firms

might decide that expansion is a trouble not worth taking fearing to lose their control inthe company. The management allocates a fixed amount for each division as part of theoverall corporate strategy. Earlier debt issues might prohibit the increase in the firmsdebt beyond a certain level.

Lease vs Buying

One way to obtain the use of an asset is to lease it. Another way is to obtain outsidefinancing and buy it. The decision to lease or to buy the asset emphasises the importanceto a comparison of alternative financing arrangements for the use of an asset. In our


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assignment we are not sure if the option 2 is lease and which type of lease is meant inoption 3.

Operating Lease

This form of leasing has several important characteristics. Operating leases are oftenrelatively short-term; the life of the lease may be much shorter than the economic life ofthe asset. Another very important characteristic of an operating lease is that it frequentlyrequires that the lessor maintain the asset. The lessor may also be responsible for anytaxes or insurance. Most interesting feature of an operating lease is that gives the lesseethe right to cancel the lease before the expiration date. (Brealey et al, 2001)

Financial Lease

With a financial lease, the lessee (not the lessor) is usually responsible for insurance,

maintenance, and taxes. It is also important to note that a financial lease generally cannotbe cancelled, at least not without a significant penalty. A financial lease is sometimes saidto be a fully amortized or full-payout lease, whereas an operating lease is said to be partially amortized. Financial leases are often called capital leases by the accountants.(Brealey et al, 2001)

Tax-Oriented Leases is in which the lessor is the owner of the leased asset for taxpurposes. Such leases are also called tax leases or true leases. In contrast, a conditionalsales agreement lease is not a true lease. Here, the lessee is the owner for tax purposes.Conditional sales agreement leases are really just secured loans. The financial leases wediscuss in this material are all tax leases. Tax-oriented leases make the most sense when

the lessee is not in a position to use tax credits or depreciation deductions that come withowning the asset. By arranging for someone else to hold title, a tax lease passes these benefits on. The lessee can benefit because the lessor may return a portion of the taxbenefits to the lessee in the form of lower lease costs. (Brealey et al, 2001)

Leveraged Leases is a tax-oriented lease in which the lessor borrows a substantialportion of the purchase price of the leased asset on a nonrecourse basis, meaning that ifthe lessee stops making the lease payments, the lessor does not have to keep making theloan payments. Instead, the lender must proceed against the lessee to recover itsinvestment. In contrast, with a single-investor lease, if the lessor borrows to purchase theasset, the lessor remains responsible for the loan payments regardless of whether or not

the lessee makes the lease payments.

Real Estate specific issues

A brief summery of advantages and disadvantages of real estates with respect to leasingand owning are described to further elaborate that in our project appraisal option leasingis most cost efficient.

Leasing/Renting a Real estate

Advantages:


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Tax Benefits: Unlike ownership, the occupancy costs of leasing are fully deductible, includingthat portion of rent attributable to the value of the land.

Stability of Costs: The long-term occupancy costs of leasing, when viewed from the usersperspective, are generally simple to estimate and typically include base rent (pure net, pure gross,or a hybrid), operating expense pass-through, amortized tenant improvements, percentage rent(retail), and the like. Although some leases may expose a user to certain capital expenditures,tenants are generally insulated from unforeseen capital costs such as the replacement ofmechanical systems, structural repairs, and roof or parking lot replacement.

Availability of Cash:Leasing typically requires less cash out of pocket than ownership alternatives, leaving morecapital to invest in the users products and services or to establish addition allocations.

Disadvantage:

Loss of Salvage Value:

Most leases provide that any improvements made by the tenant become the property ofthe landlord at the end of the lease term, or the landlord may require that the tenantremove any improvements made to the premises at the tenants expense.

Cost: For a firm with a strong earnings record, ready access to capital, and the ability to takeadvantage of tax benefits from ownership, leasing is often the more expensive alternative.

Loss of Appreciation: Leasing means the tenant does not benefit from property appreciation.

Contractual Penalties: If a leased property becomes obsolete or the business occupying thespace becomes unprofitable, the tenant must continue paying rent or face penalties for default.

Purchasing a Real estate

Although most businesses acquire property through the use of equity and debt financing,most owners are free to use the property as they wish.

Advantages:

Tax Advantages: An owner enjoys the benefit of interest and cost recovery deductions thatreduce the annual tax liability from real estate operations. The accumulated cost recoverydeductions, although taxed at the time of sale, are currently taxed at 25 percent, which is typicallyless than the users marginal tax rate applied to ordinary income and the user enjoys the benefit ofthose untaxed dollars until the property is sold. The capital gain from appreciation, whilecurrently taxed at 15 percent, is often 87 to 133 percent less than the users ordinary income taxrate.

Appreciation: An owner enjoys the benefit of capital appreciation over time.


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Debt Reduction and Equity Build-up: Assuming conventional financing, an owner enjoys debtreduction and equity build-up through amortization of the original loan amount, since bothinterest and principal are included in every mortgage payment.

Positive LeverageWhile not guaranteed and subject to change in fluctuating financial markets or rising interest rateenvironments, properties acquired with borrowed funds stand to benefit from positive leveragemeaning the yield to the owner on a leveraged investment is greater than the yield on anunleveraged investment.

Disadvantage:

Financial Liability: Although equity financing and investment capital may be readily available,a commitment to long-term debt financing often involves a 20 to 30 year amortization andpossible loan provisions that mandate pre-payment penalties if a loan is paid off prematurely.

Time Frame: The decision to purchase should be made with a holding period in mind of at leastfive years. Although historically commercial properties tend to appreciate in value, the costs ofacquisition and disposition may offset or eliminate the benefits of appreciation over a short-termholding period.

Spatial Inflexibility: Often, owned facilities do not lend themselves to the expansion orcontraction of building improvements.

Initial Capital Outlay: Most commercial lenders require equity at closing of 20 to 30 percent ofthe cost of the property acquired. This equity requirement ties up capital that could otherwise bedeployed to grow the users business.

Risks: There are numerous risks to ownership, including internal and external obsolescence,market risks, financing risks, and unforeseen capital requirements for repairs and maintenance.

Benefit of choosing Leasing (Option 3)

By leasing, it offers fixed-rate finance, It is an alternative to borrowing at the risk-free rate in order to buy the asset outright. (Pike, R. 2006 ) There are manyadvantages to leasing versus purchasing. With a primary consideration is cost. The costof a lease may be more or less than the cost to purchase and may differ among the lessees.For example, if a firm has been running at a very low profit, it might not be able to enjoy

the tax benefits of investment, tax credit and accelerated depreciation, which areassociated with the purchase of some assets. A lessor could, however take full advantageof the tax benefits and pass them along to the lessee by means of reduced lease payments.Because the lease payments is tax deductible, the after-tax cost of leasing is the sum ofthe lease payment and operating expenses less the tax shield provided by the deductibleexpenses A tax shield is the reduction in income taxes that results from taking anallowable deduction from taxable income.

If the firm choose to purchase without financing of the property, fixed assets appear onthe balance sheet. If the firm choose to lease, they do not appear on the balance sheet.


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The WACC equation is the cost of each capital component multiplied by its proportionalweight and then summing:

Where:Re = cost of equityRd = cost of debtE = market value of the firm's equityD = market value of the firm's debtV = E + DE/V = percentage of financing that is equityD/V = percentage of financing that is debt

Tc = corporate tax rate

Calculation of a weighted average cost of capital takes account of the different after-taxcosts of debt and equity and of their significance in the make up of the total capital. Theweightings used in the calculations should be based on the market value of the securitiesand not on their book or balance sheet values. (Mott, 2005)

Leverage

Leverage is most commonly used in real estate transactions; it is the amount of debt usedto finance a firm's assets. A firm with significantly more debt than equity is considered to be highly leveraged. The leverage is also considered as the use of various financialinstruments or borrowed capital, such as margin, to increase the potential return of aninvestment. (McLaney, 2003)

Leverage helps both the investor and the firm to invest or operate. However, it comeswith greater risk. If an investor uses leverage to make an investment and the investmentmoves against the investor, the loss is magnified as compared to the situation whereinvestment had not been leveraged. Thats why leverage magnifies both gains and losses.In the business world, a company can use leverage to try to generate shareholder wealth,but if it fails to do so, the interest expense and credit risk of default destroys shareholdervalue. (ACCA, 2006)

The Effect of Financial Leverage

Impact of financial leverage on the payoffs to stockholders is important to be consideredbecause financial leverage refers to the extent to which a firm relies on debt. The moredebt financing a firm uses in its capital structure, the more financial leverage it employs.Financial leverage can dramatically alter the payoffs to shareholders in the firm. However,financial leverage may not affect the overall cost of capital. If this is true, then a firmscapital structure is irrelevant because changes in capital structure wont affect the valueof the firm.


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Inflation

Existence of inflation and its effects on the future cash flows of projects being appraised

can not be ignored. Inflation brings additional problems to project appraisals. It increasesthe uncertainty and makes more difficult the estimation of the future cash flows of salesrevenue, operating costs and working capital requirements. It also influences the requiredrate of return through its effects on the nominal cost of capital. Following formula adjustnominal values of rate of return for inflation.

In the context of investment appraisals it means that two aspects of the value of moneymust be considered. The time value of money has already been catered for by the use of

present value factors which deduct interest for the time elapsed when waiting for futurecash receipts. The other aspect is the change in the value of money itself, not because ofthe time lapse, but because the inflationary process decreases its purchasing power. (Mott,2005)


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Rental property n.d, http://www.altiusdirectory.com/Realestate/rental-property.html

[assessed by 17 Aug,2009]

NPV Analysis

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