Mr. and Mrs. Smith would like to purchase, for investment, a 3-bedroom condominium apartment at LA for $ 5.2 million. The bank is offering two different loans with monthly mortgage amortization. Loan A offers 50% financing at 3.25% per annum for 25 years. Loan B offers 60% financing at 4.2% per annum for 25 years.

The apartment will be rented out and the tenant is responsible for all expenses except for maintenance and property taxes. The gross rent is $144,000 per year. Maintenance and property tax are expected to be 35% of the gross rent.

Mr. and Mrs. Smith expect to lease out the residential unit on a 2-year tenancy basis. That is, there will be no rental revision within the 2- year tenancy period. Any revision will be effective from the beginning of the third year.

Mr. and Mrs. Smith expect to sell the condominium unit at the end of 4 years. Assume that during these four years, the property will be rented out. After considering the state of the residential market, the Tays expect that the property value will appreciate at 2% per year. Assume that depreciation allowance is not applicable and that selling cost is 6% of the sale price of the property. Further assume a tax rate of 16%.

Suppose that at the end of the second year, the gross rent will be revised to reflect the cost of living. The Smiths want to use historical inflation rates to make a decision about how much CPI adjustment they should make to the gross rent in the future. They obtained the following historical information of the Consumer Price Index (CPI) data. Compute the average annual inflation rate.

Year	Consumer Price Index (CPI)
2008	100.557
2009	100.641
2010	104.944
2011	109.395
2012	112.936
2013	114.174

(a) Assume that the Smiths will use the historical 5-year average inflation rate, that is derived in your answer to (a), to adjust the gross rent at the beginning of the third year. Further assume that maintenance and property tax are expected to be 35% of gross rent. What are the before-tax IRR (BTIRR) on equity and the aftertax (ATIRR) on equity at each level of financing?

(b) Does each loan offer favourable financial leverage? Which loan would you recommend to the Smiths? State your reasons.