CFA Level 2 - Alternative Investments Session 13 - Reading 44

CFA Level 2 - Alternative Investments Session 13-Reading 44 (Practice Questions, Sample Questions) 1. Which of the following real estate investments is most appropriate for a retiree? A)Warehouses. B)Residential rentals. C)Office buildings. (Explanation: Warehouses do not usually require a lot of maintenance or management involvement, thus making them attractive investments to moderately passive investors, such as retirees.) 2. Which of the following types of real estate investments provides a total return that is relatively more heavily weighted toward periodic income? A) Residential rentals. B) Warehouses. C) Office buildings. (Explanation: Warehouse investment returns tend to be mostly in the form of periodic income, with relatively little value appreciation. Office buildings and residential rental property each offer substantial returns in the form of both current income and value appreciation.) 3. The risk associated with a non-constant rate of appreciation is most closely related to which of the following types of real estate investing? A) Warehouses. B) Raw land. C) Office buildings. (Explanation: The rate of appreciation of raw land is not constant. This represents risk because a raw land investor may have to liquidate the investment before it has reached its expected appreciated value.) 4. A real estate investment is expected to have cash flows after taxes in each of the next three years equal to CAD70,000, CAD50,000, and CAD65,000, respectively. The initial equity investment in this property is CAD600,000 and the equity reversion after taxes (ERAT) at the end of year three is estimated to be CAD500,000. The internal rate of return (IRR) for this investment is closest to: A) 5.0%. B) 8.0%. C) -7.8%. (Explanation: Using your TI BAII Plus: [CF] [2nd] [CLR WORK] 600,000 [+/–] [ENTER] [↓] 70,000 [ENTER] [↓] [↓] 50,000 [ENTER] [↓] [↓] 565,000 [ENTER] [↓[↓] (note: CF3 = 65,000 + 500,000) [IRR] [CPT] = 5.0056 percent) 5. A real estate investment is expected to have cash flows after taxes in each of the next three years equal to CAD70,000, CAD50,000, and CAD65,000, respectively. The initial equity investment in this property is CAD600,000 and the equity reversion after taxes (ERAT) at the end of year-three is estimated to be CAD300,000. Assuming an after tax return on equity of 8 percent, the net present value (NPV) for this investment is closest to: A) -CAD238,150. B) CAD202,569. C) -CAD202,569. (Explanation: NPV = -600,000 + 64,814.81 + 42,866.94 + 51,599.09 + 238,149.67 = -CAD202,569.48 Or, using your TI BAII Plus: [CF] [2nd] [CLR WORK] 600,000 [+/–] [ENTER] [↓ ] 70,000 [ENTER] [↓] [↓] 50,000 [ENTER] [↓] [↓] 365,000 [ENTER] [↓[↓] (note: CF3 = 65,000 + 300,000) [NPV] {8} [ENTER] [↓] [CPT] = -CAD202,569.48) 6. A real estate investment is expected to have cash flows after taxes in each of the next four years equal to GBP90,000, GBP55,000, GBP35,000, and GBP25,000, respectively. The initial equity investment in this property is GBP200,000 and the equity reversion after taxes (ERAT) at the end of year-four is estimated to be GBP100,000. Assuming an after tax return on equity of 8.5%, the net present value (NPV) and internal rate of return (IRR) for this investment is closest to: NPV IRR A) GBP47,268 18% B) GBP45,376 16% C) GBP41,399 15% (Explanation: Using your TI BAII Plus: [CF] [2nd] [CLR WORK] -200,000 [+/–] [ENTER] [↓] 90,000 [ENTER] [↓] [↓] 55,000 [ENTER] [↓] [↓] 35,000 [ENTER] [↓] [↓] 125,000 (note: CF3 = 25,000 + 100,000) [NPV] {8.5} [ENTER] [↓] [CPT] = GBP 47,267.91 [IRR] [CPT] = 18.39%) 7. A property was purchased for $550,000 and sold after six years for $850,000. Costs associated with the sale were $65,000 and the tax depreciation in each year was $20,000. At the time of the sale, $320,000 remained outstanding on the mortgage. The tax rate on recaptured depreciation is 28% and the long-term capital gains tax rate is 20%. The equity reversion after taxes for this property is closest to: A) $365,600. B) $449,400. C) $384,400. (Explanation: Equity reversion after taxes (ERAT) = net selling price – mortgage balance – taxes. First, compute taxes. Recaptured depreciation = 6 × $20,000 = $120,000 Tax on recaptured depreciation = $120,000 × 0.28 = $33,600 Total gain on sale = net selling price – adjusted basis Net selling price = sales price – cost of sale= $850,000 - 65,000 = $785,000 Adjusted basis = cost - accumulated depreciation = $550,000 - 120,000 = $430,000 Total gain = $785,000 - 430,000 = $355,000. long-term capital gains tax = capital gains tax rate × (total gain - recaptured depreciation) = 0.20 × (355,000 – 120,000) = 0.20 × 235,000 = $47,000 Total taxes payable = tax on recaptured depreciation + tax on long-term capital gains = $33,600 + $47,000 = $80,600 ERAT = net selling price – mortgage balance – taxes = 785,000 - 320,000 - 80,600 = $384,400) 8. Suppose you are evaluating an investment opportunity in an office building for which you have estimated the following financial characteristics: -First year net operating income (NOI) = $75,000. -Growth rate in net operating income = 5% per year. -Tax depreciation = $10,000 per year. -Annual interest expense = $9,000. -Annual total debt service expense = $12,000. -Equity investors marginal income tax rate = 36%. -Investment horizon = four years. The cash flows after taxes for years one and four are closest to: A) CFAT1 = $51,480 and CFAT4 = $50,766. B) CFAT = $42,840 and CFAT4 = $47,760. C) CFAT1 = $42,840 and CFAT4 = $50,406. (Explanation: Taxes Payable Computation: Year-1 Year-2 Year-3 Year-4 Year-1 Year-2 Year-3 Year-4 NOI (g = 5%) $75,000 $78,750 $82,688 $86,822 Less debt service (12,000) (12,000) (12,000) (12,000) Before tax cash flow $63,000 $66,750 $70,688 $74,822 Less taxes payable (20,160) (21,510) (22,928) (24,416) CFAT $42,840 $45,240 $47,760 $50,406 NOI (g = 5%) $75,000 Less depreciation (10,000) Less interest (9,000) Taxable income $56,000 times tax rate ´0.36 Income taxes payable $20,160 CFATt Computation: ) 9. Which of the following cash flow streams is most likely to have multiple IRRs? Purchase Price Cash Flow 1 Cash Flow 2 A) $1.0 million gain $0.1 million expense $1.0 million B) $1.7 million $8.0 million gain $5 million gain C) $1.8 million $10 million gain $9 million expense (Explanation: When there is a reversal in the sign of the cash flows, it is likely that there will be multiple IRR solutions. In fact, for the cash flow stream {-1.8; 10; -9} the IRRs are 13 and 343%.) 10. Which of the following statements is most accurate regarding the evaluation of real estate investments that require relatively large cash expenses during the life of the investment? A) The recommendation of the IRR and NPV methods are likely to conflict. B) Multiple internal rates may occur. C) The IRR and NPV evaluation methods will conflict at relatively low discount rates. (Explanation: When there is a reversal in the signs of the investment’s cash flows, it is likely that multiple IRRs will exist. This renders the IRR evaluation approach ineffective.) 11. Which of the following statements regarding the evaluation of mutually exclusive projects using the NPV and/or IRR approaches is least accurate? A) Whenever a conflict exists between the IRR and NPV approaches, the project with the highest IRR should be selected. B) Multiple IRRs are likely to exist when there is a relatively large change in the direction of investment’s cash flows. C) Ranking conflicts between the IRR and NPV methods are likely to result when the projects being evaluated have relatively large differences in the size of their cash flows. (Explanation: Whenever a conflict exists between the IRR and NPV approaches, the project with the highest NPV should be selected.) 12. An investment consortium is evaluating two mutually exclusive real estate investment opportunities: a multi-unit apartment complex, and a local shopping center. This investment group requires a 9% after-tax return on equity capital. For the apartment complex, net present value (NPV) and internal rate of return (IRR) analysis result in an NPV of USD7.5 million and an IRR of 11%. For the shopping center, the NPV is USD6.8 million and the IRR is 14%. If the investors require an after-tax return of 9% on either investment, which of the two investments should be undertaken? A) The apartment complex because it has the highest NPV. B) The shopping center should be selected because it has the highest IRR. C) Both investments should be undertaken because they both have positive NPVs and their IRRs exceed the required return on equity. (Explanation: Since the projects are mutually exclusive, only one may be selected. When ranking conflicts exist between the IRR and NPV approaches, the project with the highest NPV should be selected.)