Capital Expenditure Analysis - Research Paper Example

Capital Expenditure Analysis For Sale: House and Lot. Good Location. The project is a property (house and lot) in a good location that is for sale for $360,000. Further research shows that houses in the area sell for around that price; property rentals for similar assets go for $25,000 at the end of Year 1 and is expected to escalate at 10% yearly; and property values have gone up such that calculations show you can sell the house in five years for at least $500,000. Is this a good investment There are four calculations one could use to answer this question: (1) payback, (2) discounted cash flow, (3) internal rate of return, and (4) opportunity cost. But before one could make these calculations, two other sets of information are needed. First, the alternative financing schemes for the project are identified: (1) all equity, (2) all-debt, or (3) a combination of debt and equity. Second, the following variables need to be determined: (1) discount rate, (2) inflation rate, (3) risk-free rate of return, and (4) loan rate. An important set of assumptions can also be made: taxes, depreciation, and the costs of improvements and operations would be disregarded in this first stage of evaluating the alternatives. Financing Schemes An all-equity purchase means the property will be paid for in cash from personal savings or investments. In this option, the buyer withdraws $360,000 from savings or puts together one or more investors (friends or relatives) to pay the property owner this amount. An all-debt purchase means borrowing the full amount of $360,000 from the bank at a certain loan interest rate. One problem is finding a bank willing to lend the full amount of the property, not impossible given the way property prices are rising, but neither easy. The other is getting a loan maturity of five years or more to coincide with the sale date for the property. The mixed option combines savings/investments and a loan. The buyer can combine $100,000 of his money with $100,000 from a friend and borrow $160,000 from the bank. Deciding the right equity-debt mix is tricky depending on the loan rate and whether the rate is fixed or adjustable (usually annually), because rising rates would affect the cash flow. Variables There are four variables to be inputted into the formulas for the investment analysis. The (1) discount rate, which reflects the time value of money, is needed for discounted cash flow calculations. The (2) risk-free and (3) inflation rates are needed for opportunity cost calculations. We also need the risk-free rate and the (4) loan rate for the discounted cash flow and internal rate of return analysis as these affect the cash flow. The risk-free rate is the rate of return of a risk-free investment such as a Treasury Note or Bond, and acts as the benchmark for banks and businessmen in determining whether a project is worth the risk of the investment. If a risky investment gives the same return as the risk-free rate, it would not be attractive as an investor would expect to be compensated for higher investment risk. Looking at the updated statistics in the latest issue of The Economist (2007: 105), the risk-free rate, using the return for five-year Treasury Notes, ranges from 4.9% to 6.4%. The inflation rate is important because it "eats up" the value of money. If an investment gives only a return equal to the risk-free rate, the investor ends up losing money due to inflation. Therefore, the inflation rate has to be included in calculating the discount rate to ensure that the calculations take inflation into account. The table shows inflation ranging from 2.4% to 2.7%. The loan rate is the annual interest a bank charges from borrowers and may differ for each bank depending on several factors that are complex to enumerate. However, the loan rate is normally close to or between the discount and risk-free rates because loans are risky for banks (so they expect higher returns) but should not be too high to discourage borrowing. Since banks get their funds from depositors willing to accept low interest rates for the convenience of getting their funds ready, banks price their loans and deposits in such a way that they earn a profit from the spread, or difference, between these two rates. Mortgage tables (MortgageLoan.com) show that loan rates range from 5.8% (3 years adjustable) to 6.4% (30-year fixed Jumbo loan). Assuming that the higher figures are used to make the calculations more conservative, the discount rate is: r = [(1 + risk-free rate) x (1 + inflation rate)] - 1, which would give a result of r = [(1 + 0.064) x (1 + 0.027)] - 1 = 1.092728 - 1 = 9.27%. The value of 9.3% can be used for the discounted cash flow calculations. A loan rate of 9.0% can be assumed, higher than U.S. rates but a more conservative assumption that adds robustness to the results, the reason being that if using higher rates show the investment project to be attractive, then getting better (i.e., lower) loan and/or inflation rates greatly enhances the project's attractiveness (Brealey & Myers 91-94). Results and Recommendations Please refer to Table 1 for the summary calculations and notes (in [ ]). Using opportunity cost calculations, the income stream from a risk-free investment of $360,000 is compared with the income stream from the project. The results show that placing the funds in risk-free Treasury Notes gives a negative Net Present Value (NPV) due to the effects of inflation. The total opportunity cost [a] is computed to be $111,422 or the sum of the $70,333 NPV of buying the property using all-equity financing and avoiding the potential NPV loss of $41,089 from the risk-free investment. What this shows is that investing in the project is a more profitable opportunity for using the available funds at a discount rate of 9.3%. Another way of calculating the opportunity cost is to compare the return from the project (9.3%) and the return from a risk-free investment (6.4%), which shows that the investment is attractive. Using discounted cash flow (DCF), the investment project gives a positive NPV [b] of $70,333 at the end of five years. The project is attractive because it gives higher returns compared to a risk-free investment, as it should because a higher risk should give a higher return. The prudent maximum price [c] that could be paid for the property was also calculated at $436,854 which is the cash requirement at the start of the project at which the NPV 0. The calculations for the internal rate of return (IRR) at 14.1% [d] is higher than the risk-free rate, inflation rates, and the discount rate, which means that investing in the project is attractive and gives a good return on the investment. The payback [e] is five years as expected, because the initial investment can be recovered only once the property appreciates in value by the end of the fifth year and is sold. These calculations are based on some key assumptions, aside from those already mentioned, such as interest and inflation rates would not change and the property would be sold only after five years. Any of these variables could be adjusted and their effects determined using sensitivity analysis to look at possible combinations of financing, investment returns, and NPVs. Given these findings and the assumptions, the following recommendations can be made: (1) The project is attractive and, with the prevailing interest and inflation rates, up to $436,854 can be spent using all-equity financing to buy the property as a better investment opportunity. (2) Since the calculations utilized the conservative (i.e., higher) values for discount and loan rates, the project's attractiveness would be affected negatively if rates go up (because the costs and the benchmark rates used to assess the project's attractiveness, would also go up), and vice versa (lower rates = more attractive). (3) All- [f] or large- [g] debt options are not attractive (negative NPV). Mixed equity-debt [h] financing may be possible if the debt portion is below 21% of the purchase price at $360,000 or total debt of $77,000. Otherwise, the interest payments would decrease every upside potential expected from the investment. Table 1: Calculations for Capital Expenditure Analysis Given: Price (in $) 360,000 at Year 0 500,000 at Year 5 Rental 25,000 escalating at 10% yearly Inflation 2.7% Discount 9.3% Risk-free 6.4% Loan 9.0% Cash Flows 0 1 2 3 4 5 Purchase (360,000) Rental 25,000 27,500 30,250 33,275 36,603 Sale 500,000 Opportunity Cost Risk-free 360,000 383,040 407,555 433,638 461,391 490,920 (360,000) 0 0 0 0 490,920 NPV (41,089) IRR 6.4% NPV on DCF 70,333 Total Opp Cost 111,422 [a] Discounted Cash Flow (360,000) 25,000 27,500 30,250 33,275 536,603 Discount Rate 9.3% NPV 70,333 [b] Maximum (436,854) 25,000 27,500 30,250 33,275 536,603 [c] NPV $0.77 Internal Rate of Return (360,000) 25,000 27,500 30,250 33,275 536,603 IRR 14.1% [d] Payback (360,000) (335,000) (307,500) (277,250) (243,975) 292,628 [e] Debt-financed DCF (360,000) 25,000 27,500 30,250 33,275 536,603 All Interest (32,400) (32,400) (32,400) (32,400) (32,400) Principal (360,000) Net Cash (360,000) (7,400) (4,900) (2,150) 875 144,203 NPV (255,647) [f] Mix A Loan (200,000) 56% Equity (160,000) Rental 25,000 27,500 30,250 33,275 36,603 Sale 500,000 Interest (18,000) (18,000) (18,000) (18,000) (18,000) Principal (200,000) Net Cash (360,000) 7,001 9,500 12,250 15,275 318,603 NPV (110,766) [g] Mix B Loan (77,000) 21% Equity (283,000) Rental 25,000 27,500 30,250 33,275 36,603 Sale 500,000 Interest (6,930) (6,930) (6,930) (6,930) (6,930) Principal (77,000) Net Cash (360,000) 18,070 20,570 23,320 26,345 452,673 NPV 610 [h] Note: Microsoft Excel functions were used to calculate NPV and IRR. Works Cited Brealey, Richard A. and Stewart C. Myers. Principles of Corporate Finance, 7th Ed. New York: McGraw-Hill, 2003. Economist. "Economic and Financial Indicators". The Economist (June 16, 2007): 105. MortgageLoan.com. National Mortgage Rates in the U.S. June 24, 2007. MortgageLoan.com. June 24, 2007. . Read More