Debra Is Assessing an Investment in One of Two Residential

question 26

Essay

Debra is assessing an investment in one of two residential rental properties under consideration for a 3-year time frame.
Each property requires an initial outlay of $200,000 and would be sold at the end of 3 years. Debra expects that at this time she could sell property A for $300,000 and property B for $280,000. She also anticipates an increase in net rental income each year for each property. Property B is older but because of its excellent location she expects to achieve a higher net rental even though its expected sales price is likely to be a bit lower than property B.
If Debra did not want to invest in either of the two properties then she would invest the $200,000 in a managed fund of equivalent risk which is expected to pay a rate of return of 7% p.a.
The expected net income flows for both properties is shown below:
$\begin{array}{cccc}&\text { Year } 1&\text { Year } 2&\text { Year } 3\\\text { Property A } & \$ 10,000 & \$ 10,250 & \$ 10,500 \\\text { Property B } & \$ 11,000 & \$ 11,500 & \$ 12,000\end{array}$
a) Calculate the Net Present Value (NPV) of each of the two properties to assist Debra with her decision.
b) Based on the NPV analysis which property, if any, should Debra buy?
c) Indicate the assumptions on which NPV is based that may, in fact, even lead Debra to an investment decision that may be incorrect.

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