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This is one of the questions that we were given in our seminar but I am unsure on how to go about solving it.
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Canary plc is a property company which has owned a piece of land in a prime London location for a number of years. The cost of this site was £10m, but with the recession it is now only worth £8m. Canary plc is proposing to build an office block with one million square feet of usable accommodation. The building has already been designed and architects’ fees of £250,000 have been paid.Construction of the office block has been put out to tender and management has to decide between the following two proposals:
(1) Construction would take three years at a total cost of £40m. This would be paid in four equal instalments; the first instalment to be paid immediately on signing the contract, the remainder at the end of the first, second and third year. The building would be ready for letting at the beginning of the fourth year.
(2) Construction would take two years at a total cost of £37m. This would be paid in two equal instalments; the first immediately on signing the contract and the balance on completion. The building would be ready for letting at the beginning of the third year.
In each case the building once complete would have a useful life of 50 years, at the end of which time the office block would have to be demolished before the plot of land could be resold. Demolition costs are estimated at £4m. Office space can currently be let for £15 per square foot per annum.
Annual maintenance and running costs of the building would amount to £1m from the date of occupation.
Canary plc’s cost of capital is 18%. Assume that all costs and revenues occur at the end of the year to which they relate, unless otherwise stated. Ignore inflation.
Required
(a) (i) Calculate, under each alternative, the present value of the costs of construction. Which is the cheaper method of construction?
(ii) Calculate, under each alternative, the present value of all the net cash inflows. Which construction method would be preferred? Explain why this is not the cheaper method of construction.
(iii) What is the minimum rent which would need to be charged under each construction method to make it just worthwhile to develop the site?
Clearly state any assumptions you make and any reservations you might have.
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When I attempted it I thought it was straight forward but in the seminar it was more completed than I thought with the main problem caused by the time value of money.
I got the entire question wrong so any help would be appreciated 🙂
Would I be correct in saying that the 3 year construction costs would be £31.740m, and the 2 year construction costs would be £25.650m?
I got other net cash inflows for the 3 year option to be £108.85m, and the 2 year option to be £116.863m.
On that basis, option 2 is better (116.864 – 25.650 = 91.213: 108.850 – 31.740 = 16.379). Am I close?
One problem I had with this question is that my annuity table in my BPP book only goes up to 15 years, so I had to search on Google to find a 50 year table. I don’t know how to calculate annuity factors.
just split your cashflows between initial outlay, annual cashflows and scrape value/ teminal cashflows. You cannot layout a fifty year table on one sheet so you will have to culculate a terminal value of cashflows after say 3years. Disc factor is computed as (1+r)^-t eg for demolition cost it would be 1.18^-50. For an annuity it is computed as (1-(1+r)^-n)/r. Its at the top of your discount tables. Surveyors fees are sunk costs and thereforr irrelevant. Goodluck
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