An investment firm is evaluating a real estate investment project, using the discounted cash flow approach. The purchase price is $1.5 million, which is financed 20 percent by equity and 80 percent by a mortgage loan at a 9 percent pre-tax interest rate. The mortgage loan has a long maturity and constant annual payments of SI 20.000. This includes interest payments on the remaining principal at a 9 percent interest rate and a variable principal repayment that steps up with time. The net operating income (NOI) in the first year is estimated to be $170,000. NOI is expected to grow at a rate of 4 percent every year. The interest on real estate financing for the project is tax deductible. The marginal income tax rate for the investment firm is 30 percent. Using straight-line depreciation, the annual depreciation of the property is S37.500.
a. Compute the after-tax cash flows in years 1, 2, and 3 of the project.
b. It is expected that the property will be sold at the end of three years. The projected sale price is $I.72 million. The property's sales expenses are 6.5 percent of the sale price. The capital gains tax rate is 20 percent. Compute the after-tax cash flow from the property sale in year 3.
c. The investor's cost of equity for projects with level of risk comparable to this real estate investment project is 19 percent. Recommend whether to invest in the project or not, based on the NPV of the project.