Option 1:
Saxton has an option to sell the property as it is. In this option, it has to sell the property now before reconstruction and after reconstruction. The investment is less risky because of the real estate business; it is unbelievable that the property can decline in its value in future years. The rental business is increasing in Charlottesville and it is highly probable that the demand may continue in future years. In this option, it is estimated that the investor requires a 300 bps extra return on the US Treasury Bill i.e. 4% that derives a required return of 7%. The reason behind such 300 bps plus is that the investment is risky and future cash inflows are not certain like those US Treasury Bills that are most secured for US investors. The return on investment for the first years is $15,000 for as it is situation without any improvement and it is $90,034 in the first year after development. The returns are based upon the best possible information achieved from the market and its participants. There are some more costs that are required to be deducted from the perpetual value of NOI through 7% discount rate. The costs are lost rents, tenant improvements and leasing commission, these costs are required to be taken by the landlord in order to satisfy tenancy contractual arrangement. The net value of the property through these assumptions is $279,986 for its current condition without restructuring and $1.3 million after improvement. From these two options, the option to sell after restructuring of property is a viable option because the returns are higher (Exhibit: Scenario 1). The current cash flows are not certain because the figure is purely based upon the estimations and the value of the property is purely based upon the NOI, therefore the operating income must be same as estimated to generate the value specified above.
Option 2:
In the second option, it is considered that Saxton undertakes the restructuring of the property and then sell the property at the start of 6th year. In this assumption, he will enjoy the benefits for first five years, and then he will transfer the ownership to any other proposed buyer at that time. It is estimated that the discount rate at that time is 7.5% because in 5 years a change in the rates is expected, therefore 50 bps are also adding more to derive the value of the company at the end of the 5th year. The sale price of the company at the start of the sixth years through NOI and perpetuity method is $1.24 million. However, the present value of all cash flows for the five years is $1.075 million, the value is discounted at a 10 % discount rate in order to satisfy the debt structure and Saxton’s required return as well (Exhibit: Scenario 2). The present value of this investment is less than under option, one that has a present value of $1.3 million. The sale price is highly uncertain because there are many risks that can hit the value, the first risk is the failure of the business and it is possible that in 5th year it may not generate the estimated cash flows.
Option 3
The third option is through a free cash flow method, in which all debt and other related cash outflows are considered under this assumption. The free cash flows to the equity are considered because in this method the initial investment of $240,000 is also undertaken, there are the funds invested as a capital of the owner. In this valuation, it is considered that the business is about to continue for the period of perpetuity and discount rate i.e. investor’s required return. In this case, the required return is considered at 10%, i.e. high due to the future risk implications and perpetuity impact. The NPV is $245,000 with the initial investment of $240,000. The internal rate of return is 21%, which is very attractive for Saxton (Exhibit: Scenario 3).503 Cricket Road Case Solution
Recommendation:
It is recommended to go for option 3. The reason behind such recommendation is that the business is long lasting, the building can generate returns for many years that are beyond 50 years. For this, it can generate a return of 21% in cash terms, but the return is more positive because the loan repayment is for the period of 25 years and after that he can generate more positive cash inflows from this property. In order to generate these cash flows, no full time involvement is necessary for Saxton as he can continue to earn from this property along with his student and professional life. He has also involved his mother; therefore she can take care of the tenant business....................
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