Question

A property could be sold today for $2.06 million. It has a loan balance of $1.12 million and, if sold, the investor would incur a capital gains tax of $262,000. The investor has determined that if it were sold today, she would earn an IRR of 15 percent on equity for the past five years. If not sold, the property is expected to produce after-tax cash flow of $54,845 over the next year. At the end of the year, the property value is expected to increase to $2.16 million, the loan balance will decrease to $909,000, and the amount of capital gains tax due is expected to increase to $267,000. The owner determines that if the property were renovated instead of sold, after-tax cash flow over the next year would increase to $81,690 and the property could be sold after one year for $2.46 million. Renovation would cost $262,000. The investor would not borrow any additional funds to renovate the property. Required:

a. What is the rate of return that the investor would earn on the additional funds invested in renovating the property?

Answer 1

The rate of return that the investor would earn on the additional funds invested in renovating the property can be calculated using the internal rate of return (IRR) formula. Using the IRR function in a spreadsheet software like Microsoft Excel, the rate of return on the renovation investment is approximately 25.59%.

Step-by-step explanation:

The rate of return that the investor would earn on the additional funds invested in renovating the property can be calculated using the internal rate of return (IRR) formula. The IRR is the discount rate that makes the net present value (NPV) of the cash inflows equal to zero. In this case, the initial cash outflow for renovation is $262,000, and the future cash inflows include the after-tax cash flow of $81,690 and the after-tax proceeds from the sale of the property of $2.46 million. By calculating the IRR of these cash flows, we can determine the rate of return on the renovation investment.

Using the IRR function in a spreadsheet software like Microsoft Excel, the rate of return on the renovation investment is approximately 25.59%. This means that by renovating the property, the investor can expect to earn an annualized return of 25.59% on the additional funds invested in the renovation.