Suppose that you are in the real estate business. You are considering constructi

Question

Suppose that you are in the real estate business. You are considering construction of an office block. The land would cost $50,000 and construction would cost a further $300,000. You foresee a shortage of office space and predict that a year from now you will be able to sell the building for $400,000. Thus, you would be investing $350,000 now in the expectation of realizing $400,000 at the end of the year. Assume an interest rate of 7%. a. How much would you have to invest in it in order to receive $400,000 at the end of the year? b. Suppose that you have identified a possible tenant who would be prepared to rent your office block for 3 years at a fixed annual rent of $16,000. You forecast that after you have collected the third year’s rent the building could be sold for $450,000. What is the NPV?

Explanation / Answer

a) r= interest rate = 0.07

X * (1+ r) = 400000

X*(1+0.07) = 400000

X = 400000/1.07 = 373831

Hence, we have to invest 373831 in order to get 400000 at the end of 1 year.

B) This assumes that rent cash flows at the start of the year 0. We sell the building after completing the lease of 3 years.

NPV = -373831 + 16000/1 +16000 / 1.07^1 + 16000/1.07^2 + 450000/1.07^3 = 38431

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