You and your spouse have recently inherited money from a distant relative and are considering a number

Question:

You and your spouse have recently inherited money from a distant relative and are considering a number of investment opportunities, one of which would involve residential real estate. Specifically, you have an opportunity to purchase an apartment complex with 25 rental units. The total price for these units, including sales commission expense, is estimated as $500,000. You estimate that to make each unit suitable for renting, average remodeling costs of $20,000 per unit would be needed. Fifteen of the units have a single bedroom, and rent for $500 per month; the remaining units contain two bedrooms and rent for $650 per month. A friend of yours who is in the business suggests that ordinary maintenance and repair costs be budgeted, annually, at 16 percent of rental revenue. Both the purchase price of the units and the remodeling costs qualify as 27.5-year MACRS property. In terms of calculating depreciation expense for tax purposes, you can assume that MACRS based deductions for the first 27 years will be the same; in year 28 one-half year of depreciation will be deducted. (The present value, at 10 percent, of each dollar of cost-recovery spread this way is $0.3372.) If the remodeling is undertaken and annual maintenance is done as scheduled, the investment should last at least 30 years. The estimated salvage value of the investment 30 years from now is $0. You can assume that any gain/loss on this sale will be taxed at your ordinary income-tax rate. Assume an opportunity cost of capital of 10 percent for purposes of evaluating this investment proposal. You and your spouse feel that your combined income tax rate for the foreseeable future would be approximately 40 percent (Note: The required PV factors are not in Appendix C. Thus, you will need to use Excel functions to generate a PV annuity factor for 27 periods and a PV factor for period 28, at various discount rates, in order to solve this problem.)

Required

1. What is the estimated after-tax NPV of this proposed investment? On the basis of your analysis of cash flows, is this investment desirable? Why or why not?

2. How is the estimated NPV affected if the discount rate were 8 percent rather than 10 percent? How would your estimate change if the discount rate were 12 percent rather than 10 percent?

3. What additional factors might you have to consider before investing in this apartment complex?

Salvage Value
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