Consider the possible purchase of an office building for $ 8.5 million financed

Question

Consider the possible purchase of an office building for $ 8.5 million financed 70% by mortgage and 30% by equty. The cost of land was $1,275,000= and the property is depreciated on a straight line basis over 39 years. The property is leased out for 5 years and the projected NOI for year one is $ 922750 and will grow at 3% annually thereafter. The loan is amortized over a 20 year term at an interest of 10%. The capital gain tax is 15% of price appreciation and 25% on the depreciation recapture. Tax on income is 36%. The required rate of return for equity is 12%. The property can fetch $ 9.7 million at end of year 5. Compute the after tax equity IRR. Should the propert be purchased?

Explanation / Answer

5950000 Mortgage 5950000=Int.((1-(1.1)^-20)/0.1) 2550000 Equity Annual Interest =   698885 8500000 Total cost of Land& Bldg. 1275000 Cost of Land 7225000 Cost of bldg. Note Tax amt. Basis in Building (7225000-926282) = 6298718 Basis in Land 1275000 Total basis 7573718 Sale value of land& building 9700000 Difference 2126282 To be taxed @ Dep. Recap.rate of 25% 926282 231570.5 So, Balance to be taxed @ C. G. Rate 15% 1200000 180000 411570.5 Year Less:Interest on Loan Annual Depreciation Taxable income Tax @ 36% After-tax Income Add Back Depn. Net Cash flow for the year 0 -8500000 -8500000 -8500000 -8500000 1 922750 698885 185256 38609 13899 24709 185256 209966 2 950433 698885 185256 66291 23865 42426 185256 227683 3 978945 698885 185256 94804 34129 60675 185256 245931 4 1008314 698885 185256 124172 44702 79470 185256 264727 5 1038563 698885 185256 154422 55592 98830 185256 284086 5 9700000 9700000 411571 9288430 9288430 (ref. Note) Total 926282 IRR (As per Excel) 3.85% As the IRR 3.85% is well below the reqd. rate oe return 12% the property should not be purchased.

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