Caltech BEM 103 Introduction to Finance Fall 2010 Homework1

Due date: Friday October 15, 2010 In your textbook, solve problems 3.2, 4.3, 4.6, 5.1, 5.2, 5.5, 5.6, 5.7, 5.11, 6.4, 6.7, 6.8. In addition, find the NPV and IRR for the HVAC system in the attached case. (It would be good to also look at the questions following the case, to see whether youre comfortable doing them.)

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Melborne Properties, Inc.: A Capital Budgeting Problem in Real Estate Management

John T. Rose* and Charles J. Delaney**

Focus
This case involves a proposed capital improvement project on an existing real estate property. The case could be used in a real estate investment course, a real estate management course, or a corporate nance course. While not lengthy, it presents students with a real-life situation that property managers must address when deciding whether to make a major capital improvement on an existing property. It also provides students with an exercise in the use of common spreadsheet software to examine a proposed capital expenditure.

Setting
Beth Daniels, a nancial analyst with Melborne Properties, Inc., which invests in apartment complexes, ofce buildings and shopping malls, is analyzing the feasibility of replacing the heating, ventilation and air conditioning (HVAC) system in one of Melbornes malls in Atlanta, Georgia at the beginning of 2002. To date, the company has spent $15,000 researching HVAC systems worldwide to identify the most efcient, reliable system. The effort has now reached the point at which a decision must be made as to whether to proceed with the project.

Exhibits
Exhibit 1 is a schedule of modied ACRS depreciation allowances. A Microsoft Excel template for computing 1) the incremental after-tax cash ows of the mall with the replacement HVAC system and 2) the net present value (NPV) and the internal rate of return (IRR) on the project, along with completed spreadsheets, are provided with the teaching notes showing the solution to the case as well as solutions to several case-related questions.

Availability
This case, including teaching notes, is available from Managing Editor Bill Hardin, at the JREPE website or via email to bhardin@cobilan.msstate.edu.

*Baylor University, Waco, TX 79798 or JT Rose@Baylor.edu. **Baylor University, Waco, TX 79798 or Charles Delaney@Baylor.edu.

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Case Scenario
Six months ago, immediately after graduating rst in her MBA class, Beth Daniels took a position as a nancial analyst with Melborne Properties, Inc., a multi-national corporation that invests in apartment complexes, ofce buildings and shopping malls across the United States, Canada and Europe. Early on a recent Monday morning, Beths supervisor called her to his ofce to discuss her performance while at Melborne. Beth was thrilled to learn that she was being given a 10% raise because of her excellent work but, more importantly, she was being assigned her rst major project where she would be the lead analyst. Beth was told that Melborne Properties was thinking about replacing the heating, ventilation and air conditioning (HVAC) system in one of its antique/craft malls in Atlanta, Georgia at the beginning of 2002. To date, the company has spent $15,000 researching HVAC systems worldwide to identify the most efcient, reliable system. The planning has now reached the point at which a decision must be made as to whether to proceed with the project. Beth was given the le containing all the relevant data and told she had until Friday to make her recommendation to the asset manager responsible for the southern U.S. portfolio. Beth learned the proposed HVAC system will cost $3.04 million, of which 60% will be for materials and 40% for labor. Electrical work required to install the new system will add another $225,000. The new system will have a MACRS class life of seven years (see Exhibit 1). However, due to further expected improvements in HVAC technology, the system will have an economic life of only ve years, at the end of which the rm expects to sell the components of the system for a total salvage value of 10% of the original materials cost. In addition, the new system will require added expenditures on spare parts, for although the new system will be more efcient than the existing system, thereby requiring less maintenance, spare parts will be more expensive, resulting in a one-time increase in spare parts inventory of $110,000. The mall has 260,000 open-space square feet in three stories and is currently expected to generate total annual lease revenue of $4.68 million during 2002 from tenants who rent non-partitioned space on one or more oors. However, this revenue estimate represents a decline of 10% from the malls historic high revenue in 1999, as several tenants have recently vacated, in part due to problems with the current HVAC system. Specically, temperatures vary widely across oors and even on a given oor over the course of a day, generating numerous complaints from customers. Maintenance personnel have repeatedly worked on the system but have been unable to correct the problem fully and have further aggravated customers by occasionally setting off an ear-piercing re alarm. As a result, a number of tenants have refused to renew leases or have renewed only after being offered substantial discounts. Moreover, other tenants are threatening to leave when their leases expire if the problem is not corrected. Based on the schedule of current leases, lease revenue is likely to decline by 7% of its 2002 level in 2003 and 2004, followed by a drop of 10% of its 2002 level each year thereafter if the problem is not solved. Daniels believes that with the new HVAC system, Melborne could not only stem the tide of lease defections from the mall but also restore lease revenue to its historic
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high in the rst year after installing the new system. Further, the company estimates that the mall could increase lease revenue at compound annual rates of 3% in 2003 and 2004 and 5% in 2005 and 2006 due to a combination of fewer vacancies and higher lease prices as the economy improves. In addition to greater lease revenue, Daniels anticipates lower operating costs due to the enhanced efciency of the new HVAC system combined with lower maintenance costs. Together, these savings should reduce operating expenses (exclusive of depreciation) of the mall from 45% of lease revenue to 35%. The existing HVAC system was installed seven years ago at a total cost of $2.1 million and is being depreciated on a MACRS class life of seven years (see Exhibit 1). Company engineers estimate this system has a remaining useful life of ve years, at the end of which it will have no salvage value. However, components could be sold today for an estimated $100,000. The required rate of return (cost of capital) on this project is 13%. Melborne has unlimited funds to invest, faces no other constraints in its capital budgeting decisions, and is in the 38% federal-plus-state marginal tax bracket. The rms average federalplus-state tax rate is 32%.

Case Requirements
This case involves a capital budgeting decision to replace a HVAC system in an antique/craft mall. To enable you to make a decision, you should develop a Microsoft Excel spreadsheet to analyze the cash ows associated with the project. The spreadsheet should include three cash ow components: (1) computation of the initial cost of the project; (2) calculation of the incremental operating cash ows generated by the project; and (3) calculation of the terminal-year, non-operating cash ows from the project. Whenever possible, spreadsheet cells should be specied with equations using cell references so that if you were to use your spreadsheet for another

Exhibit 1 Modied ACRS Depreciation Allowances

Property Class Year 1 2 3 4 5 6 7 8 3-Year (%) 33.33 44.44 14.82 7.41 5-Year (%) 20.00 32.00 19.20 11.52 11.52 5.76 7-Year (%) 14.29 24.49 17.49 12.49 8.93 8.93 8.93 4.45

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replacement project, you would have to make only minimal adjustments to your equations. In addition to the cash ow components, the spreadsheet should include equations to compute both the net present value (NPV) and internal rate of return (IRR) on the project. This can be accomplished by specifying equations for the interest factors and present values of each of the annual net cash ows plus equations to calculate the NPV and IRR using the calculated present values. Again, spreadsheet cells should be specied with equations using cell references whenever possible. Finally, the calculated NPV and IRR should be veried using the NPV and IRR functions embedded in Excel.

Case-Related Questions
In addition to the requirements outlined above, answer the following case-related questions on a separate page using word-processing software. (You do not have to retype the questions, but please number your answers to conform to the question numbers.) To answer some of the questions, you will have to make changes to your original spreadsheet solution. However, you do not have to turn in these additional spreadsheets. 1. Based on the gures from your original spreadsheet solution, would you recommend that Melborne replace the existing HVAC system with a new system as proposed? Explain, making reference to both NPV and IRR and using specic gures. 2. Would your answer to Question 1 change if Melborne did not expect any savings in operating costs from replacing the HVAC system, i.e., operating costs (exclusive of depreciation) would remain at 45% of lease revenue? Explain, making reference to both NPV and IRR and using specic gures. 3. Would you be more or less condent in your decision about this project if Melborne did not expect any salvage value from the new HVAC system at the end of its economic life? Explain, making reference to both NPV and IRR and using specic gures. 4. Would your answer to Question 1 change if the tax law were amended to eliminate accelerated depreciation, thus requiring that the new HVAC system (but not the existing system) be depreciated over its 5-year economic life using the straight-line method? Explain, making reference to both NPV and IRR and using specic gures. Do you notice anything unusual about your answer, i.e., an answer different from what you might have expected? Explain what happened. (Note: in using straight-line depreciation for tax purposes, do not subtract the estimated salvage value from the cost of the project to calculate the depreciable basis.) 5. What is the maximum installed cost (including the $225,000 cost of electrical work) of the new HVAC system for which you would recommend that Melborne undertake this project? Explain how you determined this cost. What would be the IRR of the project in this case?
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6. Why is NPV an appropriate decision-making criterion for analyzing real estate investments? 7. How does the NPV of a project relate to the IRR on the project? 8. Why is NPV still preferred over IRR as a decision-making criterion in evaluating capital investments?

Selected Readings in Capital Budgeting

Gitman, L. J., Principles of Managerial Finance, Ninth edition, Addison-Wesley, 2000. See especially the material in Chapter 8 (Capital Budgeting and Cash Flow Principles) dealing with replacement projects. Graham, J. R. and C. R. Harvey, How Do CFOs Make Capital Budgeting and Capital Structure Decisions?, Journal of Applied Corporate Finance, 2002, 15, 823. Epps, R. W. and C. E. Mitchem, A Comparison of Capital Budgeting Techniques with Those Used in Japan and Korea, Advances in International Accounting, 1994, 7, 20514. Sangster, A., Capital Investment Appraisal Techniques: A Survey of Current Usage, Journal of Business Finance and Accounting, 1993, 20, 30732. Shao, L. P. and A. T. Shao, Risk Analysis and Capital Budgeting Techniques of U.S. Multinational Enterprises, Managerial Finance, 1996, 22, 4157.