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FNCE 333 Lecture 8

FNCE 333 Lecture 8. After-Tax Valuation Models Professor C. F. Sirmans. Administrative Issues. Check for new materials on the website. Strip Shopping Center Case – Part B, Due on Monday, April 7. Review and Objectives. Review Before-Tax Valuation Models from previous lecture

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FNCE 333 Lecture 8

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  1. FNCE 333Lecture 8 After-Tax Valuation Models Professor C. F. Sirmans

  2. Administrative Issues • Check for new materials on the website. • Strip Shopping Center Case – Part B, Due on Monday, April 7

  3. Review and Objectives • Review Before-Tax Valuation Models from previous lecture • Develop Valuation Equations to include the Tax Effects on Operation and Sale • After-Tax Valuation Models A. Without Debt B. With Debt

  4. Readings • Lusht, Chapter 15, “Finance and Tax Explicit Discounted Cash Flow Value Models”, Readings 16 and 17 • Problem Set 8 • Brueggeman and Fisher, Chapters 11 and 12

  5. After-Tax Valuation Model

  6. After-Tax Valuation:Without Debt After-Tax Cash Flow From Operation • ATCF = NOI - Taxes • Taxes = TI(MTR) • TI = NOI - Dep • Dep = (B/V)(V)(1/L) • ATCF = NOI - ((NOI - (B/V)(V)(1/L))(MTR))

  7. After-Tax Valuation:Without Debt After-Tax Cash Flow From Sale • ATER = NSP - DepRecapTax - CapGainTax • DRTax = ((N)(1/L)(B/V)(V))(DRTaxRate) • CGTax = (CG)(CGTaxRate) • CG = NSP – OriginalBasis • CGTax = ((NSP - (V))(CGTaxRate) • ATER = NSP - (N)(1/L)(B/V)(V)(DRTaxRate) - (NSP - V)CGTaxRate

  8. After-Tax Valuation:Without Debt Example A real estate investment has the following assumptions: NOI = $10,000 per year (constant) Holding Period = 10 years Reversion = Net Sale Price equal to today’s value (no change in price) All equity financed (no mortgage)

  9. After-Tax Valuation:Without Debt Example • Suppose following Tax Assumptions: Investor’s Marginal Tax Rate = 30% Capital Gains Tax Rate = 20% Recapture Tax Rate = 25% Building-to-Value Ratio = 80% Depreciable Life = 27.5 years • Required After-Tax Equity Yield (unleveraged) = 7.2% How much would the investor bid?

  10. After-Tax Valuation:Without Debt Example • Suppose: Asking Price: $102,500 Dep Ded = 102,500(.8)(1/27.5) = 2,982 ATCF = 10,000 - (10,000 - 2,982).3 ATCF = 7,895 ATER = 102,500 - (10)(2,982)(.25) - (102,500 - 102,500)(.2) ATER = $95,045 IRR = 7.2%

  11. After-Tax Valuation:Without Debt Example V = 6.9591(10,000 – ((10,000 – (.8)(V)(1/27.5))(.3)) + .4989((V – ((10)(1/27.5)(.8)(V))(.25) - (V – V)(.2)) V = 48,424 + .5233(V) V = $102, 200

  12. Financing Effects on Cash Flows:Basic Equations ATCF = NOI - DS - Taxes DS = Amt. Borrowed (Mortgage Constant) DS = L/V(V)(MC) ATER = NSP - UM - TDS UM = (L/V)(V)(Proportion Outstanding)

  13. After-Tax Valuation:With Debt • Suppose the investment is financed as follows: 75% loan-to-value 9% interest rate (interest-only) Balloon payment in 10 years • Required After-Tax Equity Rate (leveraged) = 10%

  14. After-Tax Valuation:With Debt • ATCF = NOI - (MC)(L/V)(V) - ((NOI - (L/V)(V)(i) - (B/V)(V)(1/L))(TaxRate)) • ATER = NSP - (PO)(L/V)(V) - (N)(1/L)(B/V)(V)(DRTaxRate) - (NSP – V)CGTaxRate

  15. After-Tax Valuation:With Debt • For the Example DS = .75(.09)(V) UM = .75(V) • Operating Tax Equation becomes TI = NOI - Int - Dep Int = (.09)(.75)(V)

  16. After-Tax Valuation Example: Interest-Only Mortgage The value of the investment is:

  17. After-Tax Valuation:With Debt V = .75(V) + 6.1446(10,000 - (.09)(.75)(V) - ((10,000 - (.09)(.75)(V) - (.8)(V)(1/27.5))(.3)) + .3855((V - (.75)(V) - (10)(1/27.5)(.8)(V)(.25) - (V - V)(.2)) V = 43,012 + .58165(V) V = $102, 800

  18. Discounted Cash Flow Valuation: Other Issues • How to handle amortized debt? • What about unequal NOIs? • What about Financing Costs, Prepayment Penalities, and Acquisition Costs • What should be the relationship between required rates of return?

  19. How to Value using Spreadsheet • Using the Small Apartment Building Case, what is the maximum amount that can be bid: A. No Debt and No Taxes B. No Debt with Taxes C. Debt and No Taxes D. Debt and Taxes

  20. DCF Valuation Models:Rates of Return • Note that in the example, the required rates of return are as follows: A. All Equity without Taxes – 9.75% B. Leveraged with no Taxes – 12.00% C. All Equity with Taxes – 7.2% D. Leveraged with Taxes – 10% How to interpret? Conceptually correct?

  21. DCF Valuation Models:Summary • All Equity Financed Project—No debt and no taxes • Debt and Equity combination but no Taxes • All Equity with Taxes but no Debt • Debt and Equity combination with Taxes

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