A Single-Tenant Building Has the Following Expected Future Cash Flows

question 14

Essay

A single-tenant building has the following expected future cash flows, all occurring at the ends of the years. The first three years reflect an existing in-place lease. The next six years are the expected rents under a subsequent 6-year lease, that is expected to be signed at the end of Year 3, but the amount of the rent in that subsequent lease is not certain in advance of the signing of that lease. The Year 10 cash flow includes reversion as well as subsequent operating cash flow beyond the second lease. The current T-bill yield is 6%. The risk premium appropriate for discounting contractual cash flows is 200 basis-points. The risk premium appropriate for discounting non-contractual cash flows is 600 basis-points. What is the value of this building? Please show your work for possible partial credit.)
$$\begin{array}{l}\text { Hypothetical office building net cash flows: }\\\begin{array} { | l | l | l | l | l | l | l | l | l | l | l | } \hline \text { Year } & 1 & 2 & 3 & 4 & 5 & 6 & 7 & 8 & 9 & 10 \\\hline \mathbf { C F } _ { \mathbf { t } } & \$ 2 & \$ 2 & \$ 2 & \$ 2.2 & \$ 2.2 & \$ 2.2 & \$ 2.2 & \$ 2.2 & \$ 2.2 & \$ 25 \\\hline\end{array}\end{array}$$

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Definitions:

Rate of Return

The gain or loss on an investment over a specified period, expressed as a percentage of the investment's initial cost.

Budget Line

A graphical representation of all possible combinations of two goods that can be purchased with a given budget at fixed prices.

Risky Asset

A financial instrument or investment that has a high degree of uncertainty regarding its returns or potential for loss.

Standard Deviation

An indicator of the degree to which a collection of numbers diverges or spreads from their average, signaling the extent of the distribution from the central value.