Your firm is considering purchasing an old office building with an estimated rem
ID: 2776936 • Letter: Y
Question
Your firm is considering purchasing an old office building with an estimated remaining service life of 25 years. Recently, the tenants signed long-term lease, which leads you to believe that the current rental income of $220,000 per year will remain constant for the first 5 years. Then the rental income will increase by 10% for every 5-year interval over the remaining life of the asset. You estimate the operating expenses, including taxes, will be $79,000 for the first year and that they will increase by $4000 each year thereafter. You also estimate that razing the building and selling the lot on which stands will realize a net amount of $48,000 at the end of the 25-year period. If you had the opportunity to invest your money elsewhere and thereby earn interest at the rate 13% per annum, what would be the maximum amount you would be willing to pay for the building and lot at the present time?
Explanation / Answer
We first need to compute net cash flow, then calculate their present value:
Cash flow = expected rental – operating expenses + salvage value
Present value = cash flow x PV factor
year
Expected Rental
(-) Operating Expenses
Salvage value
Net Cash flow
PV factor 13%
PV
1
220000
-79000
141000
0.885
124778.76
2
220000
-83000
137000
0.783
107291.10
3
220000
-87000
133000
0.693
92175.67
4
220000
-91000
129000
0.613
79118.12
5
220000
-95000
125000
0.543
67844.99
6
242000
-99000
143000
0.480
68685.55
7
242000
-103000
139000
0.425
59083.43
8
242000
-107000
135000
0.376
50781.58
9
242000
-111000
131000
0.333
43607.91
10
242000
-115000
127000
0.295
37412.72
11
266200
-119000
147200
0.261
38374.69
12
266200
-123000
143200
0.231
33037.08
13
266200
-127000
139200
0.204
28419.70
14
266200
-131000
135200
0.181
24427.47
15
266200
-135000
131200
0.160
20977.67
16
292820
-139000
153820
0.141
21764.95
17
292820
-143000
149820
0.125
18760.15
18
292820
-147000
145820
0.111
16158.65
19
292820
-151000
141820
0.098
13907.44
20
292820
-155000
137820
0.087
11960.34
21
322102
-159000
163102
0.077
12525.99
22
322102
-163000
159102
0.068
10813.09
23
322102
-167000
155102
0.060
9328.53
24
322102
-171000
151102
0.053
8042.44
25
322102
-175000
48000
195102
0.047
9189.69
1,008,467.69
So at the present time, maximum amount we can pay is 1,008,467.69.
year
Expected Rental
(-) Operating Expenses
Salvage value
Net Cash flow
PV factor 13%
PV
1
220000
-79000
141000
0.885
124778.76
2
220000
-83000
137000
0.783
107291.10
3
220000
-87000
133000
0.693
92175.67
4
220000
-91000
129000
0.613
79118.12
5
220000
-95000
125000
0.543
67844.99
6
242000
-99000
143000
0.480
68685.55
7
242000
-103000
139000
0.425
59083.43
8
242000
-107000
135000
0.376
50781.58
9
242000
-111000
131000
0.333
43607.91
10
242000
-115000
127000
0.295
37412.72
11
266200
-119000
147200
0.261
38374.69
12
266200
-123000
143200
0.231
33037.08
13
266200
-127000
139200
0.204
28419.70
14
266200
-131000
135200
0.181
24427.47
15
266200
-135000
131200
0.160
20977.67
16
292820
-139000
153820
0.141
21764.95
17
292820
-143000
149820
0.125
18760.15
18
292820
-147000
145820
0.111
16158.65
19
292820
-151000
141820
0.098
13907.44
20
292820
-155000
137820
0.087
11960.34
21
322102
-159000
163102
0.077
12525.99
22
322102
-163000
159102
0.068
10813.09
23
322102
-167000
155102
0.060
9328.53
24
322102
-171000
151102
0.053
8042.44
25
322102
-175000
48000
195102
0.047
9189.69
1,008,467.69
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