Question: D.J. AHOY has been very successful developing real estate in the market. The company has historically focused on the development of residential housing units. The CEO has recently become interested in commercial retail space and has identified a project that looks promising.
The retail space is for sale for $1,180,000. The land is valued at $210,000 and the building at $970,000. The building is currently leased to a quality tenant with a five-year lease at $51,000 per year. The building is located in an area that is becoming increasingly fashionable. The business broker you are working with expects that the property will be worth $1,700,000 in five years' time (assume this sale 5 years from now).
The residential investments at D.J. AHOY are currently yielding a 13% return. You have been instructed to use a 13% rate of return in your analysis of this project. At the asking price, does an NPV analysis of this project indicate that it would be a good deal? What is the IRR on the development? The CEO is considering making an offer of $995,000. At this price would the property generate an IRR sufficient to meet D.J. AHOY'S return expectations?
You will present and explain your calculations comparing the $995,000 offer and the $1,180,000 asking, and your plan to the CEO. The CEO has also asked that you include the answers to the following questions in your analysis:
1. Prepare an Excel spreadsheet comparing the two options. Create a table identifying the two complete cash flow streams. Identify and show the present values of the benefits and the present values of the costs.
2. Without changing any of the cash flows, understanding this investment may be negotiated, what is the maximum amount D.J. AHOY should offer for this to remain beneficial? (compare this third amount in your Excel sheet)
3. Do NPV and IRR analysis always agree on whether a proposed investment creates value for the firm? What evidence do you have?
4. Are there other capital budgeting techniques that we might use to evaluate this project? What are the Pros and Cons of each?