Question 42

Your friend, Sam had a rental property rented to a travel agent. The property was used to generate rental revenues of $100,000 per annum. Due to COVID19, the travel agent shut down the business and moved out of the property. Instead of renting it again to a new tenant, Sam is planning to use it for an investment opportunity. He plans to use the property for producing toilet tissues and hand sanitizer to take advantage of the recently increased demand for these products. The equipment and other setup costs will amount to $5 million, to be 100% financed from a bank loan at an interest rate of 6% per annum. The investment will generate an expected cash flow of $800,000 per year for ten years. An alternative investment with similar risk generates an expected return of 8% per annum. Your friend seeks your assistance to understand the effect of financing cost and opportunity cost in his capital budgeting decision-making.

Explain to your friend how these two 'costs' should be treated in his project evaluation. (8 marks)

Note: You are not required to calculate the NPV of the project.