Question

5. You have decided to invest in a small commercial office building that has one tenant. The tenant has a lease that calls for annual rent payments of $20,000 per year for the next 3 years. However, after that lease expires you expect to be able to increase the rent by 4% per year for the next 7 years. You plan to sell the building for $350,000 10 years from now.

a. Create a table showing the projected cash flows for this investment assuming that the next lease payment will be made in 1 year.

b. Assuming that you need to earn 9% per year on this investment, what is the maximum price that you would be willing to pay for the building today? Use the NPV function.

c. Notice that the cash flow stream starts out as a three-year regular annuity, but it then changes into a seven-year graduated annuity plus a lump sum in year 10. Use the principle of value additivity to calculate the present value of the cash flows.

d. Suppose that the current owner of the building is asking $275,000 for the building. If you paid this price, what annual rate of return would you earn? Should you buy the building at this price? 

Answer 1

Cash flow is the net movement of cash into and out of a business, project, or financial endeavor within a specific time frame, offering a crucial gauge of financial health. It encompasses operating cash flow (related to day-to-day business activities), investing cash flow (involving investments in assets), and financing cash flow (concerned with transactions with owners and creditors). Net Present Value (NPV) is a financial metric used to evaluate the profitability of an investment or project by calculating the present value of future cash flows minus the initial investment cost. The NPV formula considers the time value of money, discounting future cash flows back to their present value. If NPV is positive, the investment may generate value; if negative, it may not meet the required rate of return. Present Value (PV) is a concept used to determine the current worth of future cash flows or payments, factoring in the discount rate and time. PV formulas, applied to single cash flows or annuities, help assess the current value of money received or paid in the future. These financial tools are fundamental for decision-making in investment analysis and capital budgeting.