BUS370 Capital Budgeting Project Purchase a House vs Rent an Apartment Note: THI

ID: 2827325 • Letter: B

Question

BUS370 Capital Budgeting Project Purchase a House vs Rent an Apartment Note: THIS IS A VIRTUAL CASE FOR PRACTICE PURPOSE ONLY. THE ANALYSIS OR CONCLUSION OF THIS CASE DOES NOT IMPLY ANY INVESTMENT SUGGESTION Please analyze, from the perspective of finance, the choice of buying a house vs renting an apartment. To make a quantitative analysis, suppose you have collected the following information: 1. If you rent a 1,000 sq ft two-bedroom apartment in RTP area, your monthly rent will be S900. The 2. If you want to buy a house, a 2,000 sq ft three-bedroom townhouse in RTP area is sold at $200,000. apartment is in move-in condition. You won't have any upfront expenses when you move in. To get your application for mortgage approved by a bank, you need to pay 20% down payment. In addition, there is $2,000 closing cost. Your mortgage bank gives you two offers for mortgage. Offer one is a 30-years fixed-rate mortgage at 3.88% APR. Offer two is a five-year floating-rate mortgage, ARM 5/1, at 2.88% interest rate A townhouse owner needs to pay $80 HOA fee each month. In addition, the property tax and house insurance together are about 1.5% of house value. 3. In addition, you make the following assumptions to simplify the situation: 1. Suppose you will live in an apartment or a townhouse for five years only. After year five, you will either buy a larger single family house or move to another place. That means you need to resell your Currently, the US house market is close to bottom. So you expect in next five years, the market value of your house will increase the same as inflation rate. Based on the knowledge you've learned from economics courses, you think inflation rate might be around 3% in next five years. That implies your house value will increase at 3% each year. The utility expense of a townhouse will be higher than that of an apartment. However, considering that the interest part of your monthly mortgage payment is tax-deductible, you simply assume the extra utility expense of a townhouse and the tax-saving due to mortgage interest expense are canceled out. That means you don't need to consider utility when you do your quantitative analysis. house at year five. 2. 3. . You will pay $6,000 transaction costs when you resell the house 5. At time when you resell your house, your mortgage is not paid off yet. So you have to use the sales proceeds to pay off your mortgage first. You can find how much mortgage balance remains unpaid by checking the mortgage amortization table at www.bankrate.com. Go to this website click "calculator/mortgage calculator", then input your mortgage information and calculate monthly payment, lastly, click "amortization table",you will find your mortgage balance at end of year five. Your opportunity cost (required rate of return) is 8% 6. Based on the above information, do you want to buy a house? Why? (Hint: this is a replacement capital budgeting decision. You need to calculate incremental cash flows between housing and renting and use incremental cash flows to calculate NPV).

Explanation / Answer

I want to buy the house as present value of cost incurred towards buying the house is lesser than taking it on rent.

Present Value of purchasing the house

S.No

Particulars

Amount

Inputs to compute Present Value

Present Value at 8% using Financial Calculator

Downpayment for house at 20% of $200000

$40000

Closing Cost

$2000

HOA Fee at per month

$80

PMT = (80 x 12), I/Y = 8%, N = 5, FV = 0

$3833

Tax and Insurance per annum

$3000

PMT = 3000, I/Y = 8%, N = 5, FV = 0

$11978

Monthly mortgage payment at annual rate of 2.88% using bankrate.com

$664.26

PMT = (664.12 x 12), I/Y = 8%, N = 5, FV = 0

$31826.37

Sale value at the house at inflation of 3% perannum for 5 years = 200000 X 1.03^5

$231854.82

Selling Cost

$6000

Balance Loan using bankrate.com at the end of 5 years

$141935.95

Inflow at the end of year 5 = 6 – 7 – 8

$83917.86

PMT = 0, I/Y = 8%, N = 5, FV = (83917.86)

($57113.1)

Net Present Value of purchasing the house

Adding 1 to 5 and subtracting 9 as it is inflow and all others are outflow

$32524.29

Present value of renting the house = Present value of paying rent at $900 permonth

= PMT = 900, FV = 0, I/Y = 8%, N = 5)

= $43212.86

Present value of paying rent is higher than buying the house.