Chapter 8 – Replacement problems:

1. An investor is considering the purchase of Tata International Equity Fund (TIEF) for his
portfolio. Like many U.S.-based mutual funds today, TIEF has more than one class of
shares. Although all classes hold the same portfolio of securities, each class has a different
expense structure. This particular mutual fund has three classes of shares: A, B, and C. The
expenses of these classes are summarized in the following table:

Expense Comparison for Three Classes of TIEF

Class A Class B Class C
Sales Charge (load) on
Purchases 4% None None
Deferred Sales Charge None 5% in the first year, 1% for the initial
(load) on declining by 1 percentage two years
Redemptions point each year thereafter
Annual Expenses:
Distribution Fee 0.10% 0.50% 0.75%
Management Fee 0.75% 0.75% 0.75%
Other Expenses 0.50% 0.50% 0.50%
1.35% 1.75% 2.00%

The time horizon associated with the investor’s objective in purchasing TIEF is three years;
he decides to specify it as just over three years. He expects equity investments with risk
characteristics similar to TIEF to earn 10% per year, and he decides to make his selection of
fund share class based on an assumed 10% return each year, gross of any of the expenses
given in the table above.
Based on only the above information, determine the class of shares that is most appropriate
for this investor. Assume that expense percentages given will be constant at the given
values. Assume that the deferred sales charges are computed on the basis of net asset value
(NAV).
2. An investor is considering the purchase of CHECK Fund for his portfolio. Like many U.S.-
based mutual funds today, CHECK has more than one class of shares. Although all classes
hold the same portfolio of securities, each class has a different expense structure. This
particular mutual fund
has three classes of shares: A, B, and C. The expenses of these classes are summarized in
the following table:

Expense Comparison for Three Classes of CHECK

Class A Class B Class C
Sales Charge (load)
on 3% None None
Purchases
Deferred Sales Charge None 5% in the first year, declining 1% for the
(load) on by 1 percentage point each initial two years
Redemptions year thereafter
Annual Expenses:
Distribution Fee 0.25% 0.50% 0.75%
Management Fee 0.75% 0.75% 0.75%
Other Expenses 0.25% 0.25% 0.25%
1.25% 1.50% 1.75%

The time horizon associated with the investor’s objective in purchasing CHECK is five
years. He expects equity investments with risk characteristics similar to CHECK to earn 8%
per year, and he decides to make his selection of fund share class based on an assumed 8%
return each year, gross of any of the expenses given in the table above.
a. Based on only the above information, determine the class of shares that is most
appropriate for this investor. Assume that expense percentages given will be constant at
the given values. Assume that the deferred sales charges are computed on the basis of
NAV.
b. Suppose that, as a result of an unforeseen liquidity need, the investor needs to liquidate
his investment at the end of the first year. Assume an 8% rate of return has been earned.
Determine the relative performance of the three fund classes, and interpret the results.
3. A real estate company has prepared a simple hedonic model to value houses in a specific downtown
area. A summary list of the houses’ characteristics that can affect pricing are:
 The number of main rooms.
 The surface of the garden (if any).
 The construction material (wood or brick).
 The distance to a subway station.

A detailed statistical analysis of a large number of recent transactions in the area allowed to derive
the following slope coefficients:

Slope Coefficient in
Characteristics Units Euros per Unit
Number of Rooms Number 30,000
Surface of the Garden Square meters 200
Construction Material (bricks) 0 or 1 30,000
Distance to Subway Station In meters 100

A typical house in the area has 5 main rooms, a garden of 500 square meters, constructed with
bricks, and a distance of 300 meters to the nearest subway station. The transaction price for a typical
house was €250,000.
a. You wish to value a house that has 7 rooms, a small garden of 100 square meters, constructed in
wood, and a distance of 100 meters to the nearest subway station. What is the appraisal value
based on this sales comparison approach of hedonistic price estimation?
b. You wish to value a house that has 7 rooms, a garden of 1,000 square meters, constructed in
brick, and a distance of 1 kilometer to the nearest subway station. What is the appraisal value
based on this sales comparison approach of hedonistic price estimation?
4. An investor wants to evaluate an apartment building using the income approach. She gathers the
following data on the apartment complex; all income items are on an annual basis.

Investment under Consideration

Gross Potential Rental Income $100,000
Estimated Vacancy and Collection Losses 5%
Insurance and Taxes $ 8,000
Utilities $ 5,000
Repairs and Maintenance $ 12,000
Depreciation $ 15,000
Interest on Proposed Financing $ 6,000

Two apartment buildings have recently been sold in the area. Building A had a sales price of $5 million
with an annual net operating income of $500,000. Building B had a sales price of $1 million with an
operating income of $95,000. Except for size, both buildings have characteristics (location, age,
quality, . . .) similar to that of the apartment building under consideration.
According to the income approach, what is the value of the apartment complex?
5. An analyst is evaluating a real estate investment project using the discounted cash flow approach.
The net purchase price is $10 million, which is financed 20% by equity and 80% by a five-year
mortgage loan. The loan carries an interest rate of 7%. Annual interest expenses on the $8 million
loan are $560,000 and the loan is repaid in full after the fifth year.
The net operating income for the first year is estimated at $800,000 and is expected to grow annually
at a 3% growth rate. Using straight-line depreciation over 50 years, the annual tax depreciation of the
real estate project is equal to $200,000. It is expected that the property will be sold in five years
(just after the end of the fifth year) at a net price of $11 million.
The marginal income tax rate for this project is 30%. The capital gains tax rate is 20%.
The investor’s cost of equity for projects with level of risk comparable to this real estate investment
project is 15%.
a. Compute the after-tax cash flows resulting from the operating income for each of the first
five years.
b. Compute the after-tax cash flow for the fifth year, taking into account the resale value.
c. Compute the expected net present value (NPV) of the project and its internal rate of return
(IRR).
d. State whether the investor should decide to invest in the project.
e. Compute the expected NPV and IRR of the project if the resale price is expected to be only
$10 million.
f. State whether the investor should decide to invest in this project under this new scenario.