Genaro needs to capture a return of 40 percent for his one-year investment in a property. He believes that he can sell the property at the end of the year for $150,000 and that the property will provide him with rental income of $25,000. What is the maximum amount that Genaro should be willing to pay for the property?

Fin/571 week 5 quiz (2015) 9/9 correct answers

To calculate the maximum amount Genaro should be willing to pay for the property we need to account for both expected capital gains as well as rental income. To begin with, let’s assume he wants a return of 40% after one year and that selling price of the property at that time is expected to be $150,000. This means capital gain would equate to 33% ($50,000/$150,000), while remaining 7% would come from rental income.

Given this information then using discounted cash flow (DCF) analysis we can determine how much this expected return translates into in terms of present-day value i.e. how much he should pay for the property today if he wishes to yield an annualized return of 40%. Assuming a discount rate of 10%, then our DCF calculation would suggest that Genaro should not pay more than $71,142 ($50,000 + 0.07 x 1/1.10^1 x 25,000) which represents an intrinsic value slightly higher than anticipated selling price after one year so that he can benefit from capital gains as well as income derived from rentals during his holding period.