ntroduction:
Companies look for profitable investment options to invest its funds to earn significant rate of return on investment. In this case the Board of directors of UCW is looking to invest in a 2,000 square feet space located in Vancouver house. The 2,000 sq. ft. space is located at the first floor of the property and is expected to have number of different uses including retail, education, restaurants and other commercial purposes. Taking into consideration the above facts and on the basis of necessary assumptions this document focuses on providing a suitable recommendation to the board of directors of UCW on the optimum use of the property to maximize the return on investment (Stevens, 2018).
Identified property for investment:
The property is located at the first floor of Vancouver house in 2,000 sq. ft. area and is expected to have multiple uses including restaurant, education, retailing or any other commercial use. The decision of the board of directors of UCW to use the property would be taken after considering the alternative return from different use of the property on the basis of recommendation provided here. Hence, it is important to provide an appropriate recommendation to the board of directors to make optimum use of the property to maximum the return on investment (Price, 2016).
Details of the property and assumptions:
In order to make an appropriate recommendation about the property it is important to have complete details about the property and its different uses. Except the fact that the property is located at the first floor in Vancouver house and spread in a 2,000 sq. ft. not much is known about the property and expected revenue from the use of the property thus, following assumptions will be helpful in analyzing the property properly to make appropriate recommendation (Savvides, 2018).
The expected value of the property at the date of acquisition is $2,080,000.00 thus; UCW will have to pay $2,080,000 to take the property on lease (BROWN, 2018).
In case the property is used for restaurant:
I.It is expected that the restaurant will be able to generate annual revenue of $180,000.
II.The variable cost of running the restaurant expected to be 30% of the total revenue and the fixed cost is expected to be $20,000 per annum.
III.Annual revenue is expected to increase by 20% per annum.
IV.It is expected that the restaurant will be able to operate for a total period of 5 years after which the 2,000 sq. ft, property will have to be sold at a value of $2,500,000.
V.Rate of tax applicable is 30% on profit before tax.
VI.Cost of capital is 10% per annum.
In case the property is used for retail purposes:
I.It is expected that annual rent from retailers will approximately be $150,000 and it will stay same for a period of 5 years after which the property will have to be sold a price of $2,500,000.
II.The annual maintenance and repairing costs of the property is expected to be $25,000.
III.The tax rate applicable is 30%.
IV.Cost of capital is 10%.
In case the property is expected to be used as an educational institute:
I.It is expected that annual enrolment and admission fees to be collected from student will approximately be $250,000.
II.Annual fees are expected to increase by 10% per annum.
III.Running and maintenance cost of the institute is expected to be 40%.
IV.The fixed cost is expected to be $40,000.
V.No tax is applicable to the revenue in this case as it is an educational institute.
VI.The school is expected to run for a period of 5 years after which it will shift to another location to expand.
VII.After 5 years, the property is expected to command a value of $2,500,000.
Investment analysis:
In order to conduct a detail investment analysis of the leased property it is important to evaluate all the alternative usage of the properties to understand the most profitable opportunity exist to the board of directors of UCW to maximize its return on investment (Nuno Moutinho & Helena Mouta, 2018).
Capital budgeting techniques:
There are various techniques available to appraise the investment proposals to evaluate the most suitable proposals for an organization. In this case net present value, internal rate of return and payback period capital budgeting techniques shall be used to determine the optimum use of 2,000 lease property for the company to maximize its return on the property.
Net present value:
In case the property is going to be used as a restaurant then the net present value of the property is calculated below:
Net present value
In case the property is used as a restaurant
Year 1 2 3 4 5
Annual revenue 1,80,000.00 2,16,000.00 2,59,200.00 3,11,040.00 3,73,248.00
Less: Variable costs 54,000.00 64,800.00 77,760.00 93,312.00 1,11,974.40
Contribution 1,26,000.00 1,51,200.00 1,81,440.00 2,17,728.00 2,61,273.60
Less: Fixed costs 20,000.00 20,000.00 20,000.00 20,000.00 20,000.00
Profit before tax 1,06,000.00 1,31,200.00 1,61,440.00 1,97,728.00 2,41,273.60
Less: Tax @30% 31,800.00 39,360.00 48,432.00 59,318.40 72,382.08
Profit after tax 74,200.00 91,840.00 1,13,008.00 1,38,409.60 1,68,891.52
PV factor @10% pa 0.91 0.83 0.75 0.68 0.62
Present value of cash flows 67,454.55 75,900.83 84,904.58 94,535.62 1,04,868.35
Resale value of the property 25,00,000.00
Present value of resale value 15,52,303.31
Present value of total cash flows 19,79,967.23
Less: Cost of the property 20,80,000.00
Net present value -1,00,032.77
Thus, if the property is used as a restaurant then the NPV of the property is expected to be negative, i.e. ($100,032.77). Negative NPV clearly indicates that even if the property is leased it should never be used as a restaurant as the NPV is negative, i.e. ($100,032.77).
In case the property is going to be used for retaliating then the net present value of the property is calculated below:
Net present value
Used for retailing
Year 1 2 3 4 5
Annual rent from retailer 1,50,000.00 1,50,000.00 1,50,000.00 1,50,000.00 1,50,000.00
Less: Cost of maintenance 25,000.00 25,000.00 25,000.00 25,000.00 25,000.00
Income before tax 1,25,000.00 1,25,000.00 1,25,000.00 1,25,000.00 1,25,000.00
Less: Tax @30% 37,500.00 37,500.00 37,500.00 37,500.00 37,500.00
Net income 87,500.00 87,500.00 87,500.00 87,500.00 87,500.00
PV factor @ 10% pa 0.91 0.83 0.75 0.68 0.62
Present value of cash flow 79,545.45 72,314.05 65,740.05 59,763.68 54,330.62
Resale value of the property 25,00,000.00
Present value of resale value 15,52,303.31
Present value of total cash flows 18,83,997.15
Less: Cost of the property 20,80,000.00
Net present value -1,96,002.85
The net present value is again expected to be negative at ($196,002.85) if the property is used for retailing thus, from the business perspective it does not make any sense to invest in the property and use it for retailing purposes as NPV is expected to negative in that case (McCluskey & Anand, 2017).
In case the property is going to be used as an educational institution then the net present value of the property is calculated below:
Net present value
Used as an educational institute
Year 1 2 3 4 5
Annual enrolment and admission fees 2,80,000.00 3,08,000.00 3,38,800.00 3,72,680.00 4,09,948.00
Less: Running and maintenance expenses 1,12,000.00 1,23,200.00 1,35,520.00 1,49,072.00 1,63,979.20
Contribution 1,68,000.00 1,84,800.00 2,03,280.00 2,23,608.00 2,45,968.80
Less: Fixed costs 40,000.00 40,000.00 40,000.00 40,000.00 40,000.00
Profit before tax 1,28,000.00 1,44,800.00 1,63,280.00 1,83,608.00 2,05,968.80
Less: Tax – – – – –
Profit after tax 1,28,000.00 1,44,800.00 1,63,280.00 1,83,608.00 2,05,968.80
PV factor @ 10% pa 0.91 0.83 0.75 0.68 0.62
Present value of cash flow 1,16,363.64 1,19,669.42 1,22,674.68 1,25,406.73 1,27,890.42
Resale value of the property 25,00,000.00
Present value of resale value 15,52,303.31
Present value of total cash flows 21,64,308.20
Less: Cost of the property 20,80,000.00
Net present value 84,308.20
Net present value of the leased property is expected to be $84,308.20 if the property is used as an educational institute. Thus, considering that only the use of the property as educational institute is expected to provide positive NPV hence, the property should be used as an educational institute if the property is taken on leased for a price of $2,080,000.
Internal rate of return:
Internal rate of return of the property if the property is used as restaurant:
Internal rate of return of the property is 9% as can be seen from the calculation below.
Internal rate of return (IRR)
Used as a restaurant
Year cash flows
0 -20,80,000.00
1 74,200.00
2 91,840.00
3 1,13,008.00
4 1,38,409.60
5 26,68,891.52
IRR 9%
Considering that the IRR of the property is only 9% whereas the cost of capital is 10% hence, there is no point of taking the property on lease if the management wishes to make use of the property for restaurant purpose (Maddock & Franks, 2017).
Internal rate of return of the property if is used for retailing purpose:
Internal rate of return of the property is 8% as per the calculation below if it is used for retailing.
Internal rate of return (IRR)
Used as a retailing
Year cash flows
0 -20,80,000.00
1 87,500.00
2 87,500.00
3 87,500.00
4 87,500.00
5 25,87,500.00
IRR 8%
Considering that IRR of the property is merely 8% with the cost of capital expected to be 10% thus, the board of directors would not be prudent if it decides to take the property on lesae and use it for retailing purpose (Kuik & Nijkamp, 2018).
Internal rate of return if the property is used as an educational institution:
In case the property is used as an educational institute then the IRR of the property is 11% as can be seen from the calculation table.
Internal rate of return (IRR)
Used as an educational institute
Year cash flows
0 -20,80,000.00
1 1,28,000.00
2 1,44,800.00
3 1,63,280.00
4 1,83,608.00
5 27,05,968.80
IRR 11%
Considering that the cost of capital is 10% per annum it would be advised the board of directors to invest in the property and use it as an educational institute as the IRR in that case is 11%, i.e. higher than the cost of capital.
Payback period:
Payback period of the property is it is used as restaurant:
The payback period is expected to be approximately 4 years 228 days.
Pay-back period of the property if it is used as retailing:
The payback period is expected to be approximately 4 years 245 days.
Pay-back period of the property if it is used as an educational institution:
The payback period is expected to be approximately 4 years 197 days.
Again the payback period is least for the property if it is used as an educational institute with 4 years 197 days as opposed to 4 years 228 days and 4 years 245 days in case the property is used as a restaurant and for retailing respectively (Bannerman, 2019).
CPV analysis:
Cost profit volume analysis is an extremely useful technique for the management to evaluate different investment proposals to make important investment decisions. The graph below shows the CPV analysis of the property on the basis of alternative uses of the property.
As can be seen from the graph above that if the CPV analysis is considered it is clearly visible that the property should be used for educational purpose to maximize the profit. Considering that the costs are equal in all cases as the cost of the property for lease is not going to change irrespective of the decision of the management when it comes to the use of the property (Johansson, 2019).
Recommendation:
On the basis of investment analysis the boarder points can be summarized below.
If the property is taken on lease and used as a restaurant then the NPV of the property would be negative at ($100,032.77) thus, no investor would like to earn negative NPV hence, it would not be prudent on the part of the UCW to make investment in the property if the objective of the organization is to use the property as a restaurant. IRR of the property is 9% only which is lower than the cost of capital of 10% hence, even if the IRR is considered still it would not be recommended that the property should be taken on lease if the management is thinking to use it as a restaurant (Drury & Tayles, 2018).
Thus, the property shall definitely not be used even if taken on lease as a restaurant as the expected outcome in such case will not be financially beneficial to the organization.
Further if the management of UCW is considering taking the property on lease and it is willing to use the property for retailing then also the expected outcome will not be financially beneficial to the organization. This is because the expected net present value of the property in such scenario is expected to be again negative at ($196,002.85). Even the IRR of the property is expected to be even lower at 8% and with expected cost of capital is 10% it would not be beneficial for the organization to invest in the property. The pay-back period of investment in case the property is used for retailing is 4 years and 245 days (Danazimi Jibril, Toyin J & ., 2018).
Considering the NPV, IRR and pay-back period if the 2,000 sq. ft. property is used for retailing it would not be prudent to the board of directors of UCW to invest in the property.
However, the only business scenario that makes sense to invest in the 2,000 sq. ft. area property if it is used as an educational institute as the only time that expected NPV of the property is expected to be positive is when the property is used as an educational institute. The NPV of the property in this case expected to be $84,308.20 and with IRR of the property 11% it seems only option to the board of directors to take the property on lease and use it as an educational institute to maximize the rate of return on investment of the property (de Nooij, 2018).
Conclusion:
Taking into consideration the investment analysis and subsequent discussion above it is clear that the board of directors of UCW should only take the property on lease at a cost of $2,080,000 if the property is going to be used for educational purpose. This is because only if the property is used for educational purpose the expected NPV and IRR of the property are acceptable from the business point of view. Thus, there is no other alternative use of the property which will be financially beneficial to the organization as in both other cases, i.e. if the property is used for restaurant or for retailing NPVs in both cases are expected to be negative. IRRs of the property is also expected to 9% and 8% if used for restaurant and retailing respectively hence, the board of directors are advised to take the property on lease and use it for educational purpose to maximize return on investment in the property (Danazimi Jibril, Toyin J & ., 2017).
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