Question

ABC Investment Company (ABC) is considering the purchase of a convenient store inside a
large private housing estate which has several phases of development. The asking price for
the store is $15,000,000. ABC estimates that the annual net operating income (NOI) of the
store to be $1,200,000 in the first year. Then the NOI will rise by 4%, 6% and 8% in years 2,
3 and 4 respectively. Later on, the growth rate of NOI will stabilize at 4% per year,
indefinitely. ABC requires a 14% return on this investment.

A) Find the store’s NOIs from Year 2 to Year 7. (3 marks)
B) Calculate the present values of NOI from Years 2 to Year 7 (3 marks)
C) What is the terminal capitalization rate at the end of Year 5? (3 marks)
D) If the store is expected to be owned for five years and then sold, what would be the
reversion value for this store at the end of Year 5? (4 marks)
E) Base on above information, calculate ABC’s expected (before-tax) internal rate of
return on this investment. (4 marks)
F) Base on the calculations above, would you suggest ABC to invest in the store?
Explain. (3 marks)

Answer 1

Part-a:

Store’s NOIs from Year 2 to Year 7:

Year	Growth Rate	NOI Working	NOI
2	4%	1,200,000*1.04	1,248,000
3	6%	1248,000*1.06	1,322,880
4	8%	1322,880*1.08	1,428,710
5	4%	1428,710*1.04	1,485,859
6	4%	1485,859*1.04	1,545,293
7	4%	1545,293*1.04	1,607,105

.

Part-b:

Present values of NOI from Years 2 to Year 7:

Year	Growth Rate	NOI Working	NOI	DF Working	Discounting Factor @ 14%	Present Value
2	4%	1,200,000*1.04	1,248,000	1/1.14^2	0.769467528	960,295
3	6%	1248,000*1.06	1,322,880	1/1.14^3	0.674971516	892,906
4	8%	1322,880*1.08	1,428,710	1/1.14^4	0.592080277	845,911
5	4%	1428,710*1.04	1,485,859	1/1.14^5	0.519368664	771,709
6	4%	1485,859*1.04	1,545,293	1/1.14^6	0.455586548	704,015
7	4%	1545,293*1.04	1,607,105	1/1.14^7	0.399637323	642,259
					Present Value:	4,817,095

.

Part-c:

Terminal capitalization rate at the end of Year 5 = Required Rate of return - Growth Rate

= 14% - 4%

= 10%

.

.

Part-d:

The reversion value for this store at the end of Year 5 = NOI for Year-6/(Re-g)

= 1,545,293/(0.14-0.04)

= 1,545,293/0.10

= $15,452,932

.

.

Part-e:

At IRR ,

Present Value of Outflows = Present Value of Cash Inflows

15,000,000 = Present Value of Cash Flows for Year 1 to 5 + Present Value of the The reversion value for this store at the end of Year 5

15,000,000 = 1200,000/(1+IRR)^1 + 1248,000/(1+IRR)^2 + 1322,880/(1+IRR)^3 + 1428,710/(1+IRR)^4 + 1485,859/(1+IRR)^5 + [1,545,293/(IRR-0.04)] /(1+IRR)^5

.

.

Computing for IRR ,

We get IRR = 12.38%

.

.

.

Part-f:

Based on the calculations above,ABC should not invest in the store, since IRR from the investment in Store is less than the required rate of return of ABC (i.e. 12.38% < 14%)