Reference no: EM131923769
a. A rental property is expected to earn $9,600 yearly in net income. You expect the unit to last another 20 years before needing total replacement (i.e. its value will depreciate to zero after 20 years). If your opportunity cost of capital is the expected 7% real return you expect to be able to earn on a broad-market equity portfolio, use Excel’s present value formula to calculate the capital value of the property.
b. What is the maximum amount you would be willing to pay for renovation that would be expected to increase the useful life of the property by 20 years—i.e. if after the renovations you now expect the unit to last 40 years?
c. What happens to the unit’s capital value if “easy” monetary policy enacted by the Federal Reserve can successfully reduce broad interest rates (and hence, equity yields) by one percentage point (revert to the 20 year useful life expectancy as in part a)? Calculate the percent change in the unit’s value due to this policy (i.e. the percent difference in the calculated present value here vs. in part a above).
2. Farmland
An available tract of cleared land in East Texas has come to your attention. The land can produce a crop of cattle every year with an expected average net value of $8,000. If trees are planted, a timber crop can be harvested in 20 years with an expected net value of $300,000. Because the goal of a potential farmland investment is income, we’ll use the yield of a high-grade corporate bond portfolio for the threshold rate/ discount rate; assume high grade corporate bonds are currently yielding 4.50%. In this exercise, we’ll value the land over a 100 year timeframe.
a. Find the present value of the land if it is continually used to grow timber. Over a one hundred year timeframe, this will consist of the sum of five individual present value calculations at 20, 40, 60, 80, and 100 year periods.
b. Find the present value of the land if it is continually used to grow cattle.
c. If the land is priced at $200,000, would you consider it a good investment? Comment on how this price compares to the valuations you calculated, and comment on the effect of risk (“income variability”) on the investment decision.
d. If the land is priced at $200,000 and you expect bond interest rates to rise to 6% within the next five years, would you consider this land a good investment in either use? Calculate the present value again, using the “alternate scenario” column in the spreadsheet. Explain your answer with reference to the “Bocephus Principle” (i.e. the general relationship between asset values and interest rates).