You are a consultant for a construction company evaluating two real estate development projects. Using a 4% annual discount rate, calculate the total discounted costs, revenues, and the net present value (NPV) for each project. Based on your analysis, determine which project provides a better financial return and justify your recommendation. Case: Project 1 involves constructing 500 housing units over 3 years, with 400 units sold immediately at $120,000 each and 100 units rented for 20 years at $4,000 per year. After the rental period, the rented units will be sold at $70,000 each. Construction costs are $100,000 per unit. Additional costs include a $2,000,000 luxury sales office (year 0), annual sales personnel costs of $300,000, and project financing costs of $3,000,000 per year during construction. Project 2 entails constructing 400 units over 2 years, with 350 units sold immediately at $135,000 each and 50 units rented for 15 years at $4,500 per year. The rented units will be sold at $80,000 each after the rental period. Construction costs are $90,000 per unit. Additional costs include a $3,000,000 luxury sales office (year 0), annual sales personnel costs of $250,000, and project financing costs of $2,500,000 per year during construction.
Answer (1)
To determine the financial viability of the two real estate projects, we will calculate the Net Present Value (NPV) for each. NPV is a method used in capital budgeting to analyze the profitability of an investment or project, and it considers the time value of money by discounting future cash flows to the present.
Project 1 Analysis:
Cash Inflows :
Sales of 400 units immediately: $120,000 × 400 = $48,000,000
Rental Income (20 years, 100 units): $4,000 × 100 × 20 = $8,000,000 (discounted)
Sale of rented units after 20 years: $70,000 × 100 = $7,000,000 (discounted)
Cash Outflows :
Construction costs: $100,000 × 500 = $50,000,000
Luxury sales office: $2,000,000
Annual sales personnel costs (3 years): $300,000 × 3 = $900,000 (discounted)
Project financing costs (3 years): $3,000,000 × 3 = $9,000,000 (discounted)
NPV Calculation : NP V = ( Discounted Cash Inflows ) − ( Discounted Cash Outflows )
Cash flows for each year should be discounted using the formula: P V = ( 1 + r ) n F V Where P V is present value, F V is future value, r is the discount rate (0.04), and n is the number of years.
Project 2 Analysis:
Cash Inflows :
Sales of 350 units immediately: $135,000 × 350 = $47,250,000
Rental Income (15 years, 50 units): $4,500 × 50 × 15 = $3,375,000 (discounted)
Sale of rented units after 15 years: $80,000 × 50 = $4,000,000 (discounted)
Cash Outflows :
Construction costs: $90,000 × 400 = $36,000,000
Luxury sales office: $3,000,000
Annual sales personnel costs (2 years): $250,000 × 2 = $500,000 (discounted)
Project financing costs (2 years): $2,500,000 × 2 = $5,000,000 (discounted)
NPV Calculation : Similarly, calculate the discounted cash flows and determine the NPV.
Recommendation:
After calculating the NPVs, the project with the higher NPV should be recommended as it offers a better financial return. Compare the final NPVs of both projects to make the decision.
Understanding and applying the NPV method helps evaluate project viability comprehensively, considering the overarching financial aspects in a structured manner.
