Question

A company will invest to construct an office building in the urban area. The following assumptions are applied:

• A discount rate is accepted at 7%.

• The initial investment includes 150 million dollars at the beginning of the 1st year and 50 million dollars at the beginning of 2nd year.

• The company will rent out offices to earn income. At the beginning of the 3rd year, the company will receive a net annual rent of 10 million dollars, by renting out 70% of all the offices.

• At the beginning of the 4th year, the company will receive a net annual rent of 14 million dollars, by renting out all the offices. The net annual rent will increase by 3% per year, from the beginning of the 5th year. The rent is paid at the beginning of the 5th to 10th year.

Now the company has two options:

Option A: at the end of 10th year, the company will sell out the building at the price of 266 million dollars;

Option B: at the beginning of the 11th year, the company will spend 34 million dollars in refurbishing the office building, and will not receive rent income during the whole 11th year; from the beginning of 12th years, the company will receive a net annual rent of 21 million dollars, and the net annual rent will increase by 5% per year in the 13th, 14th, and 15th years; at the end of 15th year, the company will sell out the whole building at the price of 325 million dollars.

(1) Draw the net cash flow diagrams of the two investment options.

(2) Calculate the net present value (NPV) of the two options. You must show the calculation process.

(3) Can the internal rate of return (IRR) method be used to evaluate the financial viability of the two options? If yes, calculate IRR. If no, explain why.

Answer 1

Cash flow diagram is well presented in the images below.

NPV is also calculated using the discount rate of 7% for both the options

Also IRR can be used to evaluate the financial viability of the projects