The table below shows the key data pertaining to Marine Tower Renovation Project.

If renovated, new equity shall change for case (a) and case (b). Calculation of cash flows if not
renovated and renovated with two different new loan structures is explained below:
The cash flows from each case are generated by (i) building the loan repayment structure, (ii)
taxable income and tax expenses, (iii) cash flows from operations and (iv) after tax cash flow
from sale of property
(i) Loan repayment structure: Loan calculator is built (provided in the spreadsheet) to estimate the
loan repayment structure. Excel formulas PMT and PPMT are used in estimating the total
monthly payment and the principal amount. The difference provides the interest payment.
After estimating the interest and principal payments for the whole period, annual interest and
principal payments are calculated.
Following is the data used in estimating the monthly payment and principal payment are
number of periods = 20*12 = 240. In developing the loan repayment structure for without
renovation, total loan amount = 600,000 and monthly interest rate = 10%/12 = 0.83%
While developing the loan repayment structure for renovation, under case (a), total loan =
600,000 + (200,000*75%) = 750,000 and monthly interest rate = 11%/12 = 0.92%. Under
case (b), total loan = (820,000+200,000)*75% = 765,000 and monthly interest rate = 11%/12
= 0.92%.
Based on these numbers, the loan repayment structure for all three scenarios is developed.
(ii) Taxable income: Taxable income for the projected period is calculated as Taxable income = Net
operating income interest depreciation.
Net operating income for the projected period for without renovation scenario is estimated
based on annual growth rate of 2% and for initial year it is 90,000 and for the projected case
scenario, based on annual growth rate of 3% and for the initial year it is 90,000*(1+20%) =
108,000. Interest is considered from the loan repayment structure. Depreciation for the case
without renovation = 600,000/39 = 15,385 and for renovation case = (600,000+200,000)/39 =
20,513. Tax expenses in all the three cases are calculated as 28% of taxable income.

(iii)

After tax cash flows from operations: After tax cash flows from operations is calculated as
net operating income debt service tax expenses. Debt service is the total of interest and
principal payments for every year. All the required amounts are obtained from the steps (i)
and (ii) for all the three cases.

(iv) After tax cash flow from sale of property: This is calculated as Sale price sale costs
outstanding loan tax expenses. Sale price for the case without renovation is 905,346 and for
the case with renovation using 10% capitalization rate and net operating income for Year-8 =
125,202. Sale cost in all the cases is 6% of sale price. Outstanding loan at the end of year 7 is
obtained from loan repayment structure. Tax expenses are calculated as 28% of capital gains.
Capital gains are calculated as Sale price sale costs adjusted book value. Adjusted book
value is obtained by deducting accumulated depreciation from the gross book value (800,000
for case without renovation and 1,000,000 for case with renovation).
The outstanding loan for renovation is 750,000 for case (a) and 765,000 for case (b). As such, the
interest expenses and accordingly, total after tax cash flows are different. The table below shows
the incremental cash flows.
Question (a)

Thus, incremental return (ATIRRe) is 22.5%

Question (b)

Thus, incremental return (ATIRRe) is 38.3%

The cash outflow in year-2 represents the additional equity investment.
Question (c)
The return for case (b) is higher (38.3% vs. 22.5%) due to the additional financing. This is
obtained by positive leverage. Thus, more leverage and additional financing indicates additional
financing risk.
Question (d)
I would Richard Rambo to renovate if his opportunity cost of funds is less than 22.5%.
Furthermore, if he feels that the additional return justifies the additional financing risk and the
total risk is in his threshold, he should go with case (b) of financing for renovation.