Discounted Cash Flow Method of Valuation Part B

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Discounted Cash Flow Method of Valuation Part B

• RE 205 Real Estate Finance and Investment
  Analysis
• Lecturer Paula Raqeukai
• Week 13

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Estimating Value Through a Discounted Cash Flow

• What is Discounted Cash Flow?
• A Capital Budgeting decision-making criteria that
  are based on the time value of money

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Three Discounted Cash Flow Capital-Budgeting
Techniques

• 1. What is Net Present Value (NPV)?
• A capital-budgeting concept defined as the
  present value of the projects annual net cash
  flows less the projects initial outlay.
• Whenever the projects NPV is greater than zero,
  the project will be accepted and whenever there
  is a negative value associated with the
  acceptance of a project, it will be rejected.

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Three Discounted Cash Flow Capital-Budgeting
Techniques

• If the projects net present value is zero, then
  it returns the required rate of return and should
  be accepted.
• This accept-reject criterion is illustrated
  below
• NPV gt or 0 Accept
• NPV lt 0 Reject

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Three Discounted Cash Flow Capital-Budgeting
Techniques

• Example The firm is considering new machinery,
  for which the cash flows are shown in the table
  below. If the firm has a 12 required rate of
  return, the present value of the cash flow is
  47,678 as calculated.
• Furthermore, the net present value of the new
  machinery is 7,678. Because this value is
  greater then zero, the net present value
  criterion indicates that the project should be
  accepted.

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Three Discounted Cash Flow Capital-Budgeting
Techniques
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Three Discounted Cash Flow Capital-Budgeting
Techniques

• CALCULATOR SOLUTION
• DATA INPUT 40,000 FUNCTION KEY /-
• CFi
• 15,000 CFi 14,000 CFi 13,000 CFi 12,000 CFi
  11,000 CFi 12 i
• FUNCTION KEY NPV ANSWER 7,675

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Three Discounted Cash Flow Capital-Budgeting
Techniques

• 2. What is Internal Rate of Return (IRR)?
• A capital-budgeting technique that reflects the
  rate of return a project earns. Mathematically it
  is the discount rate that equates the present
  value of the inflows with the present value of
  the outflows.

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Three Discounted Cash Flow Capital-Budgeting
Techniques

• 3. What is Profitability index (PI)?
• A capital-budgeting criterion defined as the
  ratio of the present value of the future net cash
  flows to the initial outlay.

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Three Discounted Cash Flow Capital-Budgeting
Techniques

• What is Capital Budgeting?
• The decisionmaking process with respect to
  investment in fixed assets such as land
  buildings or real estate. Specifically it
  involves measuring the incremental cash flows
  associated with investment proposals and
  evaluating the worth of these cash flows.

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MEASURING A PROJECTS BENEFITS AND COSTS

• In measuring cash flows, we will be interested
  only in the incremental or differential cash
  flows that can be attributed to the proposal
  being evaluated.
• The projects cash flows will fall into one of
  three categories below
• (i) the initial outlay (initial cost of project)
• (ii) the differential flows over the projects
  life
• (iii) the terminal cash flow

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COMPONENTS FOR CASH FLOWS

• Investment Life (length of cash flow) No
  particular time is the right one dont use the
  always five or always ten yea rule Depend upon
  the circumstances eg. Site with 4 year lease
  based on interim use then reverts to development
  site use until lease ends and property would be
  sold for re-development
• Property with 2 year rent holiday then revert to
  market

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COMPONENTS FOR CASH FLOWS

• 2. Current income (probably the first cash flow)
  - be based on lease terms and market situations
• - Must be realistic in terms of market
  expectations
• - Carefully establish what the net income is to
  owner
• - Period will vary depending upon number and
  type of tenant. For multi-tenanted with complex
  lease arrangements monthly may be better
• - Vacancies need to be included

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COMPONENTS FOR CASH FLOWS

• 3. Income growth or changes (reflected by changes
  in annual income over time)
• - Must be based on market expectations of
  growth for that type of property
• - Dont use the CPI unless you can prove that
  growth mirrors the CPI
• - Considers economic issues
• e.g. population changes
• - retail trade figures
• - supply demand figures building
  completions
• building starts
• - trade figures
• - other relevant economic indicators

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COMPONENTS FOR CASH FLOWS

• 4. Any special one off payments or returns which
  are expected (e.g. capital improvements)

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COMPONENTS FOR CASH FLOWS

• 5. Capital growth or reversionary value (value of
  the property at the end of the cash flow)

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COMPONENTS FOR CASH FLOWS

• 6. Residual Value
• Can be used on income or other methods
  particularly if interim use
• Most common method is to apply capitalization
  rate (initial yield) to expected income in the
  year following the sale
• Can take a ballpark figure at the beginning and
  inflate at a capital growth rate
• For investment Analysis may include cost sale but
  not normally for market valuation. For valuation
  purposes you must be consistent. What even
  assumptions are built into the sales analysis
  must be included in the application.

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FOUR MAIN SOURCES OF CASH FLOWS

• Gross Income PGI (Potential Gross Income) is
  the maximum income that can be obtained from the
  property. The effective gross income (EGI)
  provides a more realistic rental situation of
  property. Gross income multipliers should be
  applied to the EGI rather than to the PGI

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FOUR MAIN SOURCES OF CASH FLOWS

• 2. Net Operating Income (NOI) Is the most
  important level of analysis for the valuer. It is
  obtained by deducting the operating expenses from
  the effective gross income. The income
  capitalization approaches and the income
  discounting approaches are applied at this level
  to provide the full value of the asset.

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FOUR MAIN SOURCES OF CASH FLOWS

• 3. Before-Tax Cash Flows (BTCF) are the
  before-tax reward to the equity owner after
  servicing the debt (after the Bank). The
  discounted cash flow approaches should start at
  this level. The present value of the equity must
  be added to the present value of the debt to
  derive the full value of the asset in a no-tax
  world

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FOUR MAIN SOURCES OF CASH FLOWS

• 4. After-Tax cash Flows (ATCF) are the residual
  reward to the equity owner. It is an after-debt
  and after-tax level (after the Bank, after the
  Queen). The present value of the after-tax
  equity must be added to the present value of the
  debt to derive the full value of the assets in a
  taxed world.

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INITIAL YIELD - ASSUMPTIONS

• All cash flows occur at one time
• Productivity is defined as the annual net
  operating income from property before debt
  service income taxes
• The projection period is for the full useful life
  of the improvements, with no consideration of the
  ownership life cycle
• Capital is recaptured from income, except for
  land, which is assumed to be constant. No
  explicit consideration is given to resale price
  changes or transaction cost

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YIELD CALCULATIONS

• Each of the situations above can be calculated as
  a discounted cash flow using the necessary
  assumptions
• Term and reversion (equivalent yield) and initial
  yield can also be calculated more simply.
• Term and reversion as an annuity of the term as a
  Deferred Perpetuity for the Reversion
• Initial yield as a Perpetuity

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APPLICATION OF INCOME METHODS

• The valuer needs to consider which assumptions to
  make explicit and which to be zero or implicit.
  The circumstances of the property to be valued
  and the market place will normally determined
  this
• If there are a significant number of rack rented
  (market rented) properties suitable as sales
  evidence and if expectations of investment life,
  capital and rental growth etc are all about the
  same
• THEN simple capitalization using initial yield
  would be suitable
• Typically this could occur with condominium
  block, industrial estates or shop-house blocks

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APPLICATION OF INCOME METHODS

• If there a number of sale properties which are no
  rack rented then at least the equivalent yield
  must be calculated to allow for the term and
  reversion
• Similarly if the property to be valued is a
  freehold interest where some rental is not at
  market value, then at least the term and
  reversion approach must be adopted to allow for
  the non-market situation of the rental
• These situations can occur with all types of
  income properties at any time but are most likely
• - if the market is in boom or bust situation
• - if the current use is interim reversion
  value may not be based on current income
• - if rentals are off-set with incentives

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APPLICATION OF INCOME METHODS

• In complex income valuation situations all
  assumptions may need to be made explicit. When
  different properties have different expectations
  of growth, vacancies, costs, investment life etc
  then it becomes necessary to use analysis where
  all cash flows are considered separately (can not
  use annuities and perpetuities) and a Discounted
  Cash Flow approach must therefore be used.
• This will typically occur with more complex
  investment properties such as shopping centres
  and office buildings but may also be appropriate
  for other properties as well
• In these situation Sales Analysis should be used
  if possible to establish a discount rate.

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DCF EXAMPLE
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The Basics of Valuing Development Sites

• As with all valuation Keep it Simple if you can
  solve the problem simply then do so..
• In many cases development properties can be
  assessed on a simple per square metre or other
  unit comparison e.g. per lot created or per unit
  built or per acre basis. You should always start
  with this type of analysis. If the result is a
  small range of unit prices this may be sufficient
  to estimate value. Even if the range is large it
  should provide an estimate for you to work
  around.
• In some cases the result needs finer tuning. This
  is when the some form of residual method may be
  used.

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HYPOTHETICAL DEVELOPMENT METHOD

• The hypothetical development method (HDM) or land
  residual method is used where the property is
  capable of development, but existing methods are
  unsatisfactory to achieve a sensible conclusion.
  The property will generally not be used at the
  highest and best legal use. The value of land
  suitable for development is related to the profit
  potential.
• This method involves the valuer in a process
  similar to a developer feasibility study. The
  process in short is
• - start with what the final product might bring
• - subtract the amount that a developer might
  typically require as a
• return
• - subtract all the other costs involved
• - this leaves you with the amount that can be
  paid for the land

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BASIS FOR HDM

• The basis for the HDM is the simple formula
• Profit VFP LC DC
• Where
• VFP Value of Finished Product
• LC Land Costs
• DC Development Costs
• The END Refer to Lab for applications