Question

On December 31,1990 Nella Lyrrad invested $500,000 to build a store for rental purposes that was completed at the end of December, 1991. At the beginning of 1992 it was fully rented to a bookstore and yearly cash rents for 1992, 1993, 1994 and 1995 were $250,000 for a total of $1,000,000. Rents and expenses were collected and paid at year-end. Her cash expenses were $100,000 in each of 1992, 1993, 1994, and 1995 for a total of $400,000. She also used straight-line depreciation (20 year life) for the building, therefore, her yearly depreciation expense was $25,000 for a total of $100,000 for the period. Her book and cash tax rates were 50 % during this period. Nella sold the building for book value in early 1996. The sale of the bookstore was the only transaction for Nella in 1996 (since she sold for book-value, there were no gains or losses, i.e., no taxes). Nella’s sister, Ibot bought a bookstore on the same day that Nella’s store was completed (December 31, 1991). Ibot paid $500,000 for her store, the same as Nella. Ibot had the exact same revenues and expenses as Nella over the period, 1992,1993,1994 and 1995. Rents and expenses were collected and paid at year-end. However, Ibot did not claim any depreciation for tax returns for the periods. Ibot’s thinking was that a potential buyer would want to look at her book value at the time of sale. On the day that Nella sold her store for $400,000, Ibot called to say that she had just sold her store that morning for $500,000.

You are not required to show any schedules except for C below.

A. Nella’ full-cycle cash flow was ____________________ B. Ibot’s full-cycle cash flow was ___________________ C. Who did the best? Compare the financial return of the two stores using any appropriate financial technique. Assume a 12% cost of capital and that the IRS does not penalize Ibot for not taking depreciation.

Answer 1

A. Nella full cycle cash flow: $ 350,000

B. Ibot's full cycle cash flow: $ 300,000

C. Return on Investment:

Full Cycle Cash Flow - Nella:

Rent Income	250,000
Less: Expenses	100,000
Less: Depreciation	25,000
Income before Tax	125,000
Less: Tax @ 50%	62,500
Net Income	62,500
Add: Depreciation	25,000
Cash Flow p.a.	87,500
Full Cycle Cash Flow [87500*4]	350,000

Full Cycle Cash Flow - Ibot:

Rent Income	250,000
Less: Expenses	100,000
Income before Tax	150,000
Less: Tax @ 50%	75,000
Net Income	75,000
Cash Flow p.a.	75,000
Full Cycle Cash Flow [75000*4]	300,000

ROI = Net Income/Investment*100

Nella = 62500/500000*100 = 12.5%

Ibot = 75000/500000*100 = 15%