Assignment 2

Syed M Ali
Student ID: 0061067459

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Executive summary
In this report, an attempt is made to evaluate a property investment project so that the
investor can make a proper informed investment decision. An investor should have a proper
knowledge about the market before investment in the real estate. In this report, a property from
Queensland is selected as an investment project for earning rental income. The cost of the
property and the cost associated with the acquisition are ascertained by market research so that
initial investment that is required for the project could be estimated. Then the estimated rental
income and the yearly expenses are ascertained so that net cash flow per year could be
ascertained. Then by using the NPV, technique of capital budgeting the project is evaluated. In
the chosen project the NPV is positive and the internal rate of return of the project is also higher
than the cost of capital Therefore at the end of the report it is recommended that the investor
should invest in the project as it is estimated that the project will give the investor positive cash
flow and positive return.

Table of Contents

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Part A...............................................................................................................................................4
Introduction......................................................................................................................................4
Background......................................................................................................................................4
Sponsor objectives...........................................................................................................................6
Funding............................................................................................................................................6
Part B...............................................................................................................................................7
5. Discounted Cash Flow.................................................................................................................7
6. Discount Rate...............................................................................................................................8
7. Net Present Value.........................................................................................................................9
8. Internal Rate of Return..............................................................................................................10
9. Risks...........................................................................................................................................11
10. Conclusion...............................................................................................................................11
11. Recommendation.....................................................................................................................12
Reference.......................................................................................................................................13
Appendices....................................................................................................................................16

Part A

Introduction
In this study, the discussion is to be made on the investment planning of an investor in
property. For this purpose, the brief discussion is to be made on the investment option in the
property. The present status of the investment project is also to be discussed in this part of the
study. After the initial part of the study, the objectives and the frame of the investment are also to
be discussed. The sources of funds for the investment are also to be studied in the discussion for
the purpose of profitability analysis of the project. On the basis of the financial and non-financial
data, analysis of capital budgeting is required to be made. Furthermore, the recommendation is
also to be made for the investor in the last part of the discussion.

Background
The proposed investment in property is situated in Caloundra Queensland. The present
status of the investment could be said as in the planning stage. As the investor is planning to
invest in the property and has no occurrence of real investment, the investment status is to be
said as in planning stage (Bierman and Smidt 2012).
The project is to invest in the property for earning rent on letting out. The property is a
restaurant located on the ground floor of Caloundra Centre Point Holiday Apartments. Caloundra
is famous tourist town in Queensland. For the purpose of business in the property investment,
the companies, and the firms are required to apply to the municipal authority of Australia for
legal requirements. Furthermore, property business in Australia also requires special attention, as

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the business is required to employ a large amount of capital (Lai and Li 2014). As per the
Australian Real Property Act 1900, the investors are required to fulfill the legal criteria, such as
the special provisions of the property investment in Queensland. The investors are required to
disclose the funding details for such investment. The rules relating to the property investment
includes facilitating the customers to get basic services like proper safety and availability of
waters. Civil Law Act 2006 also forces the property owners to ensure the road facility to the
customers and other users of the property. The Law of Property Act is to be obeyed by the
building owners to get the registration of the building or other property (van der Laan and
Teunter 2012).
In other investment criteria, the investor could invest in the stock market or in the
derivative market. In Australia, the stock market reflected an average return of 12% and the
derivative market shown an average return of 11.5% for the last 10 years (Gigler et al. 2014). As
just mentioned the real estate and the property investment project yield around 13% over the
same period (Grant 2016). Therefore, it can be said that the investment option in the properties is
better than the other investment options.
From the above discussion, it could be said that the investor is to set up the business of
investing in property by abiding the legal guidelines of the country. As per the opinion of (Gaetti
2013), risk-return analysis of a project is required to be considered by the owners in at the initial
level to analyze the profitability of the project. The security factors are required to be fulfilled by
the owners, as the safety factors are to be taken as the most important factor in Australia.
Therefore, it can be said that the investor is required to abide by the Australian property laws
with preference with the other business factors such as risk-return analysis.

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Sponsor objectives
The investor in this project is looking for a secure long-term investment for 10 years. The
investment is secured because the property is available with a secure 10 years lease. The property
is expected to grow at the rate 6% per year in valuation so at the end of the investment life cycle
the investor will also enjoy a capital gain. All this makes the property investment project
attractive and safe (Finnerty 2013).

Funding
The capital for the project is to be accumulated by the owner for the purpose of
investment in the property. There are two sources of funding one internal source and another
external source. In the internal source, the investor has options like funding from an internal
source of capital and in the external source; the required fund can be borrowed from lenders.
There are certain advantages and disadvantages in both the sources internal and external sources
of funding. The internal source of funding is more costly as the investor cannot get a tax benefit
for the cost of internal sources of capital but it is the most secured way of funding a project
(Sehgal et al. 2015). The external sources of funding are less costly but there is high risk
associated with this type of funding. Therefore, a mix of both the internal and external sources of
the fund is used for financing the project so that risk and cost can both be effectively managed.
The mix of financing that is used in the current property investment project is 20% own funding
and 80% external funding.

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Part B

5. Discounted Cash Flow

The discounted cash flow statement is prepared by applying the concept of time value of
money. The concept of time value of money states that amount of money paid or received at a
future date is of more value than the amount received at the current date. The discounted cash
flow statement finds the appropriate value of future cash flow at present value term. The
discounting term is used because the present value of the cash flow is always lower than the
future value of cash flow (French 2013). The Discounted cash flow analysis techniques are used
to calculate the present value of the future cash flow of the finance and real estate project. The
procedure that is used under this method for valuing the real-estate project consists of three steps.
The forest step is to forecast expected future cash flow from the project. The second step is to
establish the required rate of return and the third step is to calculate the present value of the
future cash flow by using the discounting rate (Demong et al. 2014). The expected future cash
flow of the project is prepared by estimating a cash flow for the future period. In order to prepare
the cash flow we use the following values:

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The funding of the project is to be done using two sources of finance that are own capital and
borrowed funds (Enever et al. 2014). The funds are borrowed at the rate from 3.39% from the
lenders. The expected return on capital is 1.89%, therefore, the weighted average cost of capital
comes to 3.09%. The anticipated revenue is calculated by estimating the annual rental income
which is $114660.00. The expense that is estimated per annum is $21073.00, for calculating the
discount cash flow the inflation rate is taken, is 3%. On the basis of the above-estimated revenue
and expenses, the discounted cash flow statement is prepared for 10 years. The analyses of the
discounted cash flow statement are given below.

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In the initial year, cash outlay is $1572856.00 and from the next year the rent received
and the annual expenditure amount is adjusted with the inflation figure. The project starts to earn
profit from the first year of its operation. The actual profit from the property investment project
has continued to grow from the first year until the 10 th year. The discounted profit, however, has
continuously fallen for each preceding year but it has remained positive. After conducting a
thorough analysis of the discounted cash flow of the investment project, it can be said that the
project is profitable and will give a positive return for 10 years (Jandhyala 2013).

6. Discount Rate
The discounted cash flow is prepared by applying appropriate discount rate. The discount
rate chosen is dependent on multiple factors. The calculation and the factors are discussed
hereafter to provide appropriate justification for choosing the discount rate. The discount rate
used for evaluating the investment project is calculated by adding the weighted average cost of
capital, risk margin on investment and profit margin required from the investment. The weighted
average cost of capital indicates the average rate that is expected to be paid to the financers of the
assets (Mishan 2015). The risk-free rate of return from 10-year government bond is 1.89% so this
is used as the opportunity cost for calculating of equity capital. This opportunity cost of 1.89% is
used for calculating the weighted average cost of capital. The interest rate of 3.39% taken for
calculating WACC is chosen from various alternatives as shown in the appendices. Then the
weighted average cost of capital is calculated and that comes to 2.34%. Then with the WACC,
the risk margin is added. The risk margin is the value that takes into account the volatility of the
market. The more volatility means higher risk margin and lower volatility means low-risk
margin. The risk margin rate that is used for the current project is 3% based on the current
market volatility. The profit margin of 6% that is added is based on the general market

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conditions. The profit margin is the profit that is expected from the project. Therefore, the
discount rate that is used for evaluating the investment property project is 12.09%. It can be seen
from the above discussion that the discount rate adopted in evaluating the project is based on
detailed calculation and after taking into account the general market condition.

7. Net Present Value

There are three different options available to investors for analyzing the project these
three options are net present value, payback period method and internal rate of return. Many
investors for evaluating the projects primarily use the net present value methods. It is because
this method considers the time value of money and it gives concrete numbers to the investors for
comparing the initial cash outlay with the discounted return (Luukka and Collan 2015). The Net
Present value can be defined as the difference between the present value of cash inflows and
present value cash outflows. If the net present value of an investment project is positive then it
indicates that the anticipated earning of the project is more than the cost of the project.
Therefore, it can be said that if the net present value of the project is positive then the project
should be undertaken as this project is profitable. If on the other hand, the net present value of
the project is negative then it is advisable that investment should not be made on that project. A
project with the positive NPV should be accepted and this is the basic concept for evaluating the
project based on net present value and this is known as NPV rule (Bozorgi 2015).
In the current property investment project, the net present value of the discounted cash
flow is $101,760.00. Then as per the NPV rule, the project should be accepted, as the discounted
cash flow from the project is positive. This positive cash flow of $101760.00 indicates that after
taking into account all the cash outflow of the project from the beginning to the end of the

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project life cycle of 10 years the investment project is producing a positive cash inflow for the
investor. Therefore, if the project is to be analyzed based on NPV then the project should be
adopted. On analyzing the discounted cash flow, it is clear that the estimated payback period of
the project is the tenth year (Koudijs and Salisbury 2016). This means that more than half of the
project life cycle will be required to recover the initial cash outlay. When a projected is evaluated
based on the payback period method then projects with less payback periods are accepted over
the projects having a higher payback period. Therefore, the investor should appropriately analyze
the project and should not base its conclusion by using only one evaluation method.

8. Internal Rate of Return

The internal rate of return measures the profitability of the investment project and it is
very useful in evaluating various investment proposals. The internal rate of return is that
discounting rate at which the present value of cash inflow is equal to present value of cash
outflow. If the internal rate of return is used then the net present value of the project will be
equal to zero. In general, a project with the internal rate of return more than the cost of capital is
considered profitable so it will be beneficial for the company to undertake such projects. In
evaluating an investment project, the investor usually establishes the required rate of return it is
the minimum rate of return required by an investor (Ohman et al. 2013). If the Internal rate of
return of the project is less than the required rate of return then the project should be rejected. If
the internal rate of return of the project is more than the required rate of return then the project
should be accepted. This is known as the Internal Rate of Return rule. An analysis of the project
based only on the IRR will not give the complete picture so it should be used along with the
NPV to make the appropriate decision.

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In the property investment project, the internal rate of return is 12.97% the required rate
of return is 10.34%. Based on the internal rate of return rule the project should be accepted as the
higher IRR than the cost of capital suggest that the project will be profitable.

9. Risks
The investment project is evaluated based on estimates. The estimates are prepared based
on the current informations available and as the circumstances change the estimates of the
projects changes (Sen 2013). The risk, therefore, can be defined as the difference between the
original outcome and the expected outcome of the project. In the current property investment
project, the occupancy rate of the property is estimated to be 98% based on the current
information available. If the demand for the commercial property declines in the coming years
then it will affect the occupancy rate that is initially estimated. If the occupancy rate that is
initially estimated changes then the cash inflow per year will also be affected. This, in turn, will
affect the calculations of net present value, payback period and the internal rate of return thus the
entire evaluation criteria will change. In such circumstances, the project that was initially thought
to be profitable may due to changed circumstances become loss making. The risk that the actual
outcome of the project may differ from the original outcome is inherent in every project
evaluation (Hebek et al. 2014).
Although commercial properties give higher yield as compared to residential properties
but that comes with some risks which is listed below

There is always a possibility that there may not be any tenant available for long term
lease.

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There is a possibility that the property could be rented to bad tenants. That means

irregular rent, damage to the property etc.

There is a risk that expense could grow more than your expectation due to frequent repair
and maintenance work as commercial properties are expose to a large number of visitors.

10. Conclusion
The analysis of the property investment project in Queensland has shown that a property
in that area will cost $1500000. In addition to this, another $72856.00 will be required to
complete the project. Therefore, the total cash outflow will be $1572856.00. The annual rental
income of the property is $114660.00 and it is adjusted in accordance with the inflation rate
(Zhou 2014). After analyzing the statement, showing the calculation of the net present value and
IRR it can be seen that the project has a positive net present value of $101760.00 and the IRR is
12.97%. As can be seen both the indicators shows a positive sign except the fact that the pay
beck period of the cash flow is in 10th year.
Another factor which makes this property more attractive that a long-term lease is already in
place and property is located in one of the busiest tourist spots in Queensland

11. Recommendation
. Based on the above analysis of the discounted cash flow statement of the project and after
evaluating the net present value and the internal rate of return of the project it is recommended
that the property investment proposal should be accepted.

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In order to avoid the risk associated with the investment in this property, investor can take
following steps

To improve the chances of securing the long-term lease, consider offering incentives such

as rent reduction or rent free period.

It is always a good idea to run a tenant audit report so that you get good tenants with

positive credit history.

Investor can reduce their repair and maintenance expense following maintenance

checklist and do personal inspection

An investor should arrange for a lawyer to take care of all legal formalities for the
property.
.

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Gigler, F., Kanodia, C., Sapra, H. and Venugopalan, R., 2014. How Frequent Financial
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Sehgal, S., Upreti, M., Pandey, P. and Bhatia, A., 2015. Real Estate Investment Selection and
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Appendices
Property Cost and Expense

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Comparison of Interest Rate

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Calculation of Stamp duty

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Calculation of Opportunity Cost

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