1. Five alternative proposals have been made for the development of a commercial

Question

1. Five alternative proposals have been made for the development of a commercial rental property The required land is available on option at a price of $100,000. The following estimates have been made for the plans Annual Disbursements (Not Including Investment in Building Annual ReceiptsIncome Taxes) Plan A Plan B Plan C Plan D Plan E S 80,000 160,000 260,000 364,000 520,000 S 14,700 24,200 33,800 41,900 55,000 S 38,900 65,800 96,300 117,800 145,200 The estimated life of the building is 40 years with zero terminal salvage value. For the purpose of this analysis it is to be assumed that this land will be sold for its original cost of S 100,000 at the end of a 40-year analysis period. Calculate the before-income tax rate of return for each plan. If the stipulated before-tax i* is 8% which plan should be selected.

Explanation / Answer

i* = 8%

Net revenue (annual) = Annual receipts - Annual disbursements

time period = 40 years

rate of return = r

Plan A:

Equating the present cost with the future cash flows discounted using rate of return 'r':

Investment in building + land = PV of annual net revenues + PV of salvage value of land

100000 + 80000 = 24200/(1 + r) + ..... + 24200/(1 + r)40 + 100000/(1 + r)40

Solve for 'r':

r = 13.41%

Similarly,

Plan B: r = 15.97%

Plan C: r = 17.34%

Plan D: r = 16.33%

Plan E: r = 14.49%

Plan C has the highest rate of return and therefore, the same should be selected.

Investment ($) Annual Receipts ($) Annual Disbursements ($) Net Annual Revenue ($) Plan A 80000 38900 14700 24200 Plan B 160000 65800 24200 41600 Plan C 260000 96300 33800 62500 Plan D 364000 117800 41900 75900 Plan E 520000 145200 55000 90200

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