BUSI 331. Suggested Answers to Review and Discussion Questions: Lesson 7

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1 BUSI Suggested Answers to Review and Discussion Questions: Lesson 7. To calculate the net operating income, first determine the gross potential income for Years and 6: Year Calculation Gross Potential Income 0 - $0 (information is given above) $800,000 $800,000 x.08 $86,000 $86,000 x.08 $9,0 $9,0 x.08 $,007,770 $,007,770 x.08 $,088,9 6 $,088,9 x.0 $,,8 Then, calculate the operating expense amount for each year by creating a table as follows: Year Calculation Gross Potential Income 0 - $0 (information is given above) $00,000 $00,000 x.06 $0,000 $0,000 x.06 $6,800 $6,800 x.06 $9,08 $9,08 x.06 $6,8 6 $6,8 x.06 $669, Alternatively, you can directly calculate the corresponding operating expense for Years and 6 as follows: operating expense $00,000 ( 0.06) t, where t n- operating expense for Year $00,000 ( 0.06) $6,8 operating expense for Year 6 $00,000 ( 0.06) $669, Note that the value for Year 6 operating expense is slightly different between the table and calculated directly due to rounding differences. Net operating income (NOI) is the before-tax revenue generated from a real estate property, effective gross income, minus all relevant operating expenses. Gross Potential Income $,088,9 $,,8 LESS: Vacancy and Credit Losses (76,87) (79,997) Effective Gross Income $,0,0 $,06,8 LESS: Operating Expenses (6,8) (669,) Net Operating Income (NOI) $ 80,966 $ 9,70

2 Review and Discussion Questions: Answer Guide Page. Before-tax cash flow () equals net operating income (NOI) minus mortgage payments. Net Operating Income (NOI) 80,966 9,70 LESS: Mortgage Loan Payments (0,8) (0,8) Before-Tax Cash Flow $ 7,8 $ 88,8 The monthly mortgage payment is stated, but can be calculated as follows: PRESS DISPLAY 8 NOM% 8 P/YR EFF% 8.6 P/YR NOM% PV,0,000 0 FV 0 0 N 0 PMT -7,.008 The monthly mortgage payment is $7,, rounded up to the next higher dollar, and the annual mortgage payment is $0,8 ($7, ).. To calculate the income tax expense, accountants multiply the tax rate by the taxable income for a fiscal year, not the net operating income of that year. Taxable income deducts the interest payments on loans and capital cost allowance from the net operating income. Net Operating Income (NOI) $ 80,966 $ 9,70 LESS: Interest on Mortgage Loan (7,) (6,68) Income Before CCA $08, $, LESS: CCA on Building (9,0) (88,66) Taxable Income 6,9,88 Tax Rate % % Income Tax Expense $ 7,668 $ 8,

3 Review and Discussion Questions: Answer Guide Page Using the HP 0bII calculator to solve for the interest expense, the calculator steps continue as follows: (continued) PRESS DISPLAY 7 /- PMT -7, 9 INPUT 60 AMORT PER , INPUT 7 AMORT PER , Calculations for CCA claimed on the building years to 6: Year UCC CCA rate CCA claimed $,0,000 x 7% $,66,00 % x ½ % $,0 $,66,00 - $,0 $,609,0 % $0,70 $,609,0 - $0,70 $,0,880 % $00,9 $,0,880 - $00,9 $,0,68 % $96,87 $,0,68 - $96,87 $,08,98 % $9,0 6 $,08,98 - $9,0 $,6,8 % $88,66. After-tax cash flow () equals minus income tax expense. Before-Tax Cash Flow $ 7,8 $ 88,8 LESS: Income Tax Expense (7,668) (8,) After-Tax Cash Flow $ 99,7 $ 0,897. Cash Flow Analysis Gross Potential Income 00,000 0,00,68,6,7 Vacancy (%) 0,00 0,868,8,6,09 Effective Gross Income 89,00 99,6 0,0 0,97,08 Operating Expenses 0,000,0 60,68 66,08 7,8 Net Operating Income 9,00,8 9,6,666 60,079 Debt Service 78,68 78,68 78,68 78,68 78,68 Before Tax Cash Flow 6, 66, 7,68 76,98 8,9 Taxes on Operation 8,69,7,86 9,96 9,66 After Tax Cash Flow,7,90, 7,00,9 After-Tax Equity Reversion Disposition Price $,700,000 Transaction Costs (8%) $6,000 Net Sale Price $,6,000 Outstanding Balance $99,8 Before Tax Equity Reversion $7,78 Taxes on Reversion $99,7 After-Tax Equity Reversion $7,99

4 Review and Discussion Questions: Answer Guide Page Notes: () Debt Service j %; j.98699%% PV $,0,000; FV 0; N 00 PMT $6,, rounded up to the next higher dollar Annual Debt Service $6, $78,68 () Taxes on Operation Net Operating Income 9,00,8 9,6,666 60,079 Interest,90,7,87,87 9,8 Taxable Income before CCA 8,98 90,68 96,99 0,79 0,8 CCA,000,60 9, 7,9 0 Taxable Income 6,98 9,98 7, 6,6 0,8 Taxes on Operation (tax rate %) $8,69 $,7 $,86 $9,96 $9,66 Annual Debt Service 78,68 78,68 78,68 78,68 78,68 Interest,90,7,87,87 9,8 OSB 99,8.00 Capital Cost Allowance (a) Only one-half of the ordinary CCA amount can be taken during the first year of operation. No CCA can be taken during the year of disposition. (b) Calculation of Undepreciated Capital Cost (UCC) Purchase Price (Building) $,00,000 Max CCA (): ½ 0.0 $,00,000 $,000 CCA claim allowed $,000 UCC () $,09,000 Max CCA (): 0.0 $,09,000 $,60 CCA claim allowed $,60 UCC () $987,80 Max CCA (): 0.0 $987,80 $9, CCA claim allowed $9, UCC () $98,6 CCA (): 0.0 $98,6 $7,9 CCA claim allowed $7,9 UCC () $90,9 CCA (): no CCA allowed 0 UCC () $90,9

5 Review and Discussion Questions: Answer Guide Page () Taxes on Reversion Calculation of Capital Gain Gross Disposition Price Transaction Costs Net Disposition Price Purchase Price UCC Entire Property,700,000 6,000,6,000 Building (7%),7,000 0,000,7,000,00,000 90,9 Land (%),000,000 9,000 0,000 0,000 Capital Gain on Building Net Disposition Price - Purchase Price $,7,000 - $,00,000 $,000 Capital Gain on Land Net Disposition Price - Purchase Price $9,000 - $0,000 $,000 Total Capital Gain $,000 $,000 $6,000 Taxable Capital Gain $6, $8,000 Calculation of CCA Recapture Since land is a non-depreciable asset, only recapture on the building can be calculated. The building has appreciated, so there is full recapture of CCA. Recapture (Building) Purchase Price - UCC $,00,000 - $90,9 $9,607 Taxes on Reversion Taxable Capital Gain CCA Recapture tax rate ($8,000 $9,607) % $,607 % $99,7 6. After-Tax Present Value of Equity ( i) ( i) ( i) ( i) ( i) ATER ( i) $, 7 ( 0.06) $,90 ( 0.06) $, ( 0.06) 7, 00 ( 0.06) $, 9 ( 0.06) $ 7,99 ( 0.06) $,98 After-Tax Present Value of Equity $,98 After-Tax Net Present Value of Equity (NPVE) Present Value of Equity Initial Investment After-Tax Net Present Value of Equity (NPVE) $,98 - $80,000 $,98 Justified Investment Price PV Equity Value of Debt $,98 $,0,000 $,6,98

6 Review and Discussion Questions: Answer Guide Page 6 7. Before-Tax Present Value of Equity Derivation of discount rate: DISB DISA % ( 0.) ( MRT) ( i) ( i) ( i) ( i) ( i) BTER ( i) $ 6, ( 0.09) $ 7, 78 ( 0.09) $ 66, ( 0.09) $ 7, 68 ( 0.09) $ 76, 98 ( 0.09) $ 8,9 ( 0.09) $60, Before-Tax Present Value of Equity $60, Before-Tax Net Present Value of Equity (NPVE) Present Value of Equity Initial Investment Before-Tax Net Present Value of Equity (NPVE) $60,- $80,000 $, Justified Investment Price PV Equity Value of Debt $60, $,0,000 $,7, Before-tax discounted cash flow analysis will not take into account the effects of income tax on investor returns. In this case, the analysis generates a NPVE of $,, while the analysis generates a NPVE of $,98. The value from the analysis is higher than the value from the analysis indicating that tax treatment has a negative impact on this investment.

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