Using Future Cash Flows in a Financial Analysis

¶ … investment in a rental/real estate property. There is a one-time purchase of $10,000 in land that can subsequently be rented for a yearly $3,500 rent for a period of several years. At the end of the rental period, the investor aims to sell the land for a certain price. The longer the period of the rental is, in number of years, the more the land will degrade and, as a consequence, will be valued at a lower sum at the end of the entire period of time.

As a consequence, the several scenarios that will be taken into consideration will look at a comparison between longer years of rental vs. lower price for the final sale of the land or a shorter period for the rental period, but a higher price for the final sale at the end of the rental period.

This paper will look at three different scenarios that will be analyzed according to criteria such as the net present value (looking at present worth and future worth and discounting future worth in order to obtain present worth), the internal rate of return (IRR) and other methods that include the cost effectiveness and benefit-cost instruments. The conclusion should be able to summarize as to which of the three scenarios is the optimal for the investor.

Another important element that needs to be defined is the discount rate that will be used in all the different calculations. The discount rate will be equivalent to the cost of capital, namely how much it would cost to receive a loan in order to pay for the investment in the rental property. The assumption for the rest of this paper is that this discount rate/cost of capital will be equal to 12%, which, in the Excel sheets, will be shown as 0.12.

For the first part of the paper, the hypothesis will be described for each of the three scenarios.

Scenario A

The investment in the rental property is worth $10,000. This will be shown in the financial analysis as Year 0. Each of the first three years of the renting the property produces an even $3,500 per year (Year 1, Year 2 and Year 3). The property will be sold in the 4th year for $3,500. This will be the result of the property gradually depreciating through time and losing its value as it has been more and more used during the rental period.

Scenario B

The investment in the rental property is worth $10,000. This will be shown in the financial analysis as Year 0. Each of the first three years of the renting the property produces an even $3,500 per year (Year 1, Year 2 and Year 3). The property will be rented for another 2 years for $3,500. However, this will result in the property been more damaged at the end of the rental period, which will mean that it can only be sold for $$1,500 in the last year (Year 6), which will be the recorded cash flow for the respective year.

Scenario C

The investment in the rental property is worth $10,000. This will be shown in the financial analysis as Year 0. In this scenario, the property will only be rented out for three years and will be sold in Year 3 for a larger sum, the result of the property being less deteriorated over the rental period. The property will be sold in Year 3 for $4,500, which will be the cash flow for Year 3.

To resume, here are the following three scenarios that will be analyzed using the method previously mentioned in the introduction

Scenario A

Year

Cash Flows

0

($10,000)

1

$3,500

2

$3,500

3

$3,500

4

$3,500

Scenario B

Year

Cash Flows

0

($10,000)

1

$3,500

2

$3,500

3

$3,500

4

$3,500

5

$3,500

6

$1,500

Scenario C

Year

Cash Flows

0

($10,000)

1

$3,500

2

$3,500

3

$4,500

Financial Analysis (for all these analyses, the calculations are undertaken in the Excel spreadsheet. For each of the scenarios, a separate sheet was created, with the different values and the calculations for NPV, IRR etc.)

1. Net present value. The net present value takes into consideration the present value of the future cash flows that the project (in this case, purchasing a rental property) is likely to generate. For each of the years, in each of the scenarios, there is a cash flow that is discounted with the cost of capital (12%) in order to obtain its present value. Each of the sums of the future cash flows are then compared to the initial cost of the project, which is $10,000 and which is shown as -$10,000 in all the calculations.

This project used the automatic Excel function in order to evaluate each of the different scenarios. However, this can also be calculated manually by dividing the cash flow value for each year by 1.12 (112% = 100 + the 12% discount rate) and adding up the totals, then subtracting $10,000, the total cost of the project from that.

The results were as follows:

Scenario A: $563.15

Scenario B: $3,014.88

Scenario C: ($787.33)

The resulting is concluding and very interesting. Scenario B. was the best scenario for the investment, with Scenario A the second and Scenario C. not only the third, but also unprofitable. Scenario B. was the scenario that had the longest period of exploitation time (5 years) and the lowest sell off value in the last year. Scenario C, which was the worst, had a higher sell off value, but a smaller number of years for the exploitation. Given the fact that the intermediate project, with three years of exploitation and sell off for a value between the two, came in second, one can conclude that the longer the number of years of exploitation, the most profitable the rental is, despite the fact that the sell off value is lower.

2. Internal rate of return. According to the Project Economics and Decision Analysis volume, the internal rate of return determines what discount rate makes the NPV zero. As we have seen, during the different scenarios, the NPV takes different values at a 12% discount rate, under different operational scenarios. The IRR will determine, for each of the scenarios, what the discount rate should be for the project to become positive.

The conclusions are correct and validate the NPV. Here they are below.

Scenario A: 14.96%