Question

1. The building (not the business) is currently for sale. The asking price is $10,203,034.

If the amount you can earn on alternative investments is 5.25% does this investment make sense? Could using NPV help with this question? You can consider a 20 year timeline. How much would the rent need to be to cover your monthly debt service based on $1 million down, a 5.0% interest rate, over a period of 20 years? This is a 20 year absolute net lease (tenant pays all operating expenses), so you don't need to consider operating expenses.

2. What is the primary goal of management related to the firm? Based on finance theory, what is the value of "any" asset, at any point in time? How does the concept of "valuation" help tie these two ideas together?

Answer 1

Part (1)

The price to be paid ≤ Present value of all the future lease rentals the owner is going to get

Making use of concept of NPV, we note that if E is the expected rental then, Present value of all the future lease rentals the owner is going to get = E / k where k = capitalization rate which can be surrogated by your opportunity cost of 5.25%

Hence, this investment make sense, if rental yield > 5.25% or expected annual lease rental > k x ask price = 5.25% x  $10,203,034 = $  535,659.29

How much would the rent need to be to cover your monthly debt service based on $1 million down, a 5.0% interest rate, over a period of 20 years? This is a 20 year absolute net lease (tenant pays all operating expenses), so you don't need to consider operating expenses.

Loan amount = Cost - down payment = $10,203,034 - 1,000,000 = 9,203,034

PV = - loan amount = -9203034

Rate = 5% / 12 = 0.4167%

Period = 12 x 20 = 240 months

Hence, monthly payment = PMT (Rate, Period, PV) = PMT (0.4167%, 240, -9203034) = $ 60,735.95

Hence, the rent needed to cover your monthly debt service = PMT = $ 60,735.95

Part (2)

The primary goal of management related to the firm:

• is to maximize shareholders’ wealth
• is to undertake projects that create maximum wealth for shareholders
• is to grow the financial wealth of the company and its shareholders

Based on finance theory, what is the value of "any" asset, at any point in time?

Value of an asset at any point in time should be nothing but the present value of all the future cash flows that it can generate.

How does the concept of "valuation" help tie these two ideas together?

• Let's llok at equity valuation, for the purpose of explaining this question. Now, the stock should be purchased if it’s NPV positive i.e. price today is lesser than the present value of all the future cash flows the stock can generate. Another way to look at it will be that the investment in the stock makes sense (read acceptable) if price of stock today ≤ the present value of all the future cash flows it can generate. This is another way of saying that the investment should be accepted if it’s NPV ≥ 0.
• An acquisition as well as divestiture also involves a net initial investment and incremental after tax cash inflows. The acceptance or rejection of these should also be governed by the same criteria that price paid today ≤ present value of all the incremental benefits it can bring in future. This is precisely saying that the investment should be NPV positive.

Thus the concept of valuation ties is the value of an asset with the primary goal of management of the firm.