Solution is as below: Calculation required in reaching the below 2 numbers: 1) p

Question

Solution is as below:

Calculation required in reaching the below 2 numbers:

1) pv(tax-subsidy of debt) 9.79

2) PV(Project) @0.0616 (Year 6) 285.67

Five years ago, City-Real, AS purchased Maine Street One, a commercial property located within the city's prime business district. Since the year of purchase, however, operational expenses have far exceeded increases in the general price-level, while rental income has remained effectively constant. Hence, due to steadily decreasing yields, City-Real has decided to sell Maine Street One. Within a time frame of the next five years, top management is uncertain with regards to the optimal timing of a sale. Valuation of the property is also required based on input data provided in the table on the next page. Assume that City-Real's owners, required rate of return is 10%, that the before-tax borrowing rate is 5%, and that a marginal tax rate of 28% applies to ordinary income as well as capital gains. Also, assume that a constant loan-to-value (LTV) ratio of 60 percent is maintained throughout the maximum holding-period of five years. End-of-current year 5 (since purchase) accounting data is presented next along with estimates (budget data) of operating data, book values, and sale prices for years 6 - 10 since purchase (corresponding to year 1 through 5 from the present point in time)

Explanation / Answer

Part 1)

To calculate the present value if tax-subsidy of debt, we need to discount the interest tax shield for each year. The formula for calculating present value is given below:

Present Value (Tax-Subsidy of Debt) = Interest Tax Shield Year 6/(1+Discount Rate)^1 + Interest Tax Shield Year 7/(1+Discount Rate)^2 + Interest Tax Shield Year 8/(1+Discount Rate)^3 + Interest Tax Shield Year 9/(1+Discount Rate)^4 + Interest Tax Shield Year 10/(1+Discount Rate)^5

______

Using the values provided in the question, we get,

Present Value (Tax-Subsidy of Debt) = 2.3692/(1+0.07)^1 + 2.3996/(1+0.07)^2 + 2.4017/(1+0.07)^3 + 2.3916/(1+0.07)^4 + 2.375/(1+0.07)^5 = $9.79

______

Part B)

The present value of project for Year 6 will comprise of 2 components - present value of free cash flow and present value of tax-subsidy. The present value of free cash flow and tax-subsidy for Year 6 is calculated as follows:

Present Value of Free Cash Flow = FCF Year 7/(1+Discount Rate)^1 + FCF Year 8/(1+Discount Rate)^2 + FCF Year 9/(1+Discount Rate)^3 + FCF Year 10/(1+Discount Rate)^4

+

Present Value (Tax-Subsidy of Debt) = Interest Tax Shield Year 7/(1+Discount Rate)^1 + Interest Tax Shield Year 8/(1+Discount Rate)^2 + Interest Tax Shield Year 9/(1+Discount Rate)^3 + Interest Tax Shield Year 10/(1+Discount Rate)^4

Using the values provided in the question, we get,

Present Value of FCF (Year 6) = 17.36/(1+0.07)^1 + 18.8/(1+0.07)^2 + 19.52/(1+0.07)^3 + 300.16/(1+0.07)^4 = $277.569

+

Present Value (Tax-Subsidy of Debt) = 2.3996/(1+0.07)^1 + 2.4017/(1+0.07)^2 + 2.3916/(1+0.07)^3 + 2.3750/(1+0.07)^4 = 8.104

Present Value of Project = 277.569 + 8.104 = $285.67

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