Financing Costs and NPV Analysis in Finance and Real EstateDelaney, Charles J;Rich, Steven P;Rose, John T

Journal of Real Estate Portfolio Management; Jan-Mar 2008; 14, 1; ABI/INFORM Global

pg. 35

Financing Costs and NPV Analysis inFinance and Real EstateExecutive Summary. Business students majoring in real estate encounter seemingly contradictory treatment of financing costs in net present value (NPV) analysis between the finance and real estate disciplines. This study examines the difference in the treatment of financ- ing costs between finance and real estate textbooks, rec- onciles the difference, and recommends that real estate textbooks explicitly address this issue to minimize stu- dents' confusion and to give them a better understandingof NPV analysis.* Baylor University, Waco, TX 76798-8004 or Charles- Delaneybaylor.edu.**Baylor University, Waco, TX 76798-8004 or Steve_Richbaylor.edu.***Baylor University, Waco, TX 76798-8004 or JT_Rosebaylor.edu.

by Charles J. Delaney* Steven P. Rich** John T. Rose***Most collegiate schools of business require stu- dents to take a course in the principles of finance as part of their undergraduate business core. In addition, business students majoring in real estate typically begin their real estate curriculum with a course in the principles of real estate which, given the close relationship between finance and real es- tate, necessarily overlaps with the principles of fi- nance.! For example, both courses introduce stu- dents to the analytics of investing in real assets, including the technique of net present value (NPV) analysis." However, seemingly contradictory treat- ment of financing costs in NPV analysis across the two disciplines can be confusing for real estate stu- dents who must take both courses." Thus, this study examines the difference in the treatment of financing costs between finance and real estate textbooks, reconciles the difference, and recom- mends that real estate textbooks explicitly address this issue to minimize students' confusion and to give them a better understanding of NPV analysis."Textbook Treatment of FinancingCosts in NPV AnalysisWhile some finance textbooks explicitly address fi- nancing costs when discussing NPV analysis of capital investment projects, other texts make no mention of such costs. A review of eight finance principles texts, which (in their full-length or ab- breviated edition) account for nearly 80% of the in- troductory finance textbook market, revealed that only four books-Brealey, Myers, and MarcusJournal of Real Estate Portfolio Management 35Charles J. Delaney, Steven P. Rich, and John T. Rose(2004), Keown, Martin, Petty, and Scott (2006), Moyer, McGuigan, and Kretlow (2006), and Ross, Westerfield, and Jordan (2007)-specifically men- tion financing costs in discussing NPV analysis." But all four books are consistent in arguing (1) that NPV analysis should focus on the total in- vestment outlay to purchase the assets of a project without any adjustment for how the assets will be financed, and (2) that financing costs should not be considered in calculating the cash flows expected from the project. Likewise, the remaining four textbooks can be viewed as implicitly arguing for the irrelevance of financing costs in NPV analysis since these books ignore such costs in their capital investment examples.Noting the finance discipline's position of ignoring financing costs in NPV analysis, Brealey et al. (2004, p. 219) state: "(A) company may decide to finance partly by debt but, even if it did, we would neither subtract the debt proceeds from the re- quired investment nor recognize the interest and principal payments as cash outflows." The reason is twofold. First, finance theory teaches that in evaluating new projects, the focus should be on the incremental cash flows generated by the assets of the project, which are unaffected by the manner in which the assets are financed. Second, as Keown et al. (2006, p. 298) note, "(w)hen we discount the incremental cash flows back to the present at the required return, we are implicitly accounting for the cost of raising funds to finance the new project. In essence, the required rate of return reflects the cost of the funds needed to support the project."Moreover, in the finance approach to NPV analysis the relevant "cost of funds" for a project of the same risk as the firm's existing assets should be the firm's weighted average cost of capital (WACC) as calculated using weights from the firm's market-value target capital structure." It is nec- essary to calculate the WACC using the market values of the debt and equity capital since inves- tors' required rates of return (which serve as the "costs" for calculating the WACC)are based on the market values of the capital components. Finance texts uniformly mandate that the WACC be cal- culated using debt and equity weights calculated from market values rather than book values [e.g.,36 Vol. 14, No.1. 2008

Brealey et al. (2004, pp. 328-29), Ross et al. (2007, p. 372), and Moyer et al. (2006, p. 408)]. In addi- tion, finance texts typically argue that firms should use a consistent cost of funds for all projects of the same risk, even if different projects are actually funded by different mixes of debt and equity, say, at different points in time. Otherwise, a firm might discount two projects of the same risk by different required rates of return if the firm focused on the specific manner of financing, which would distort the calculated NPV's of the two projects [e.g., the discussions in Keown et al. (2006, p. 340) and Moyer et al. (2006, p. 409)].In contrast with finance texts, the most popular real estate textbooks, including Larsen (2003), Floyd and Allen (2005), Miller and Geitner (2005), and Ling and Archer (2008), routinely recognize fi- nancing costs and the degree to which a real estate investment is to be financed with debt. As a result, the NPV calculation in real estate texts typically subtracts the amount of any debt financing from the total investment outlay and deletes any debt service requirements from the net cash flows ex- pected from the project. In so doing, the analysis focuses solely on the equity investment and the projected cash flows, net of any principal and in- terest payments, to the investing firm (the equity investor). As Ling and Archer (2008, p. 498) note, "... in many cases, property owners use a combi- nation of equity and mortgage debt to finance an acquisition ... Therefore, the (equity) investor's cash flows from operations will be reduced by any payments that are required to stay current on (i.e.,'service') the mortgage." And since only the netcash flows to the equity investor are recognized for valuation purposes, the discount rate is typically the equity investor's required rate of return.So which approach is correct in valuing a potential real investment? Should NPV analysis focus on the total investment outlay for the project, ignore the financing mix, and use the investing firm's WACC as the discount rate, as finance textbooks argue? Or should the analysis focus solely on the equity investment, subtract any debt service payments from the expected cash flows from the project, and use the rate of return required on the equityFinancing Costs and NPV Analysis in Finance and Real Estateinvestment as the discount rate, as real estate textbooks maintain?ReconcilingNPV Analysis in Finance and Real EstateConsider a real estate investment firm with a market-value capital structure consisting of 40% equity and 60% debt, which is the firm's target (op- timal) capital structure. Assume further that the firm's cost of equity and debt, as calculated from the market values of the firm's common stock and debt outstanding, are 15% and 7% (pretax), re- spectively, and that the firm's marginal tax rate is35%. With this information, the firm's WACCcan be calculated as:WACC = (0.15 * .40)

+ (0.07 * (1 - 0.35) * 0.60)

$1,170NPVA = 1.0873 - $1,000= $1,076.06 - $1,000 = $76.06. (2)

By contrast, in a typical real estate textbook ex- ample, the 75%-25% debt-equity financing mix would likely be factored directly into the analysis by focusing on the equity investment and subtract- ing the debt service requirements from the ex- pected cash flow.In that case, the net cash flow tothe equity investor would be $1,170 - $750 * (1 +0.07(1 - 0.35)), and the NPV of the equity invest-ment (NPVE), which is the usual focus in a real estate principles text, would likely be calculated as:NPV = $1,170 - $750 * [1 + 0.07(1 - 0.35)]

E 1.15

- $250 = $335.54 - $250 = $85.54. (3)

= 0.0873.

(1) But this amount differs from NPVA> suggesting dif- ferent NPVs for the project's assets and the equityAssume now that the firm is analyzing a prospec- tive one-year investment project of the same risk as the firm's existing assets. The project will cost (net investment outlay) $1,000 and is expected to generate a net cash flow at the end of the year of$1,170, including net operating income plus sale proceeds. Assume further that the project will be funded 75% by debt from a one-year, interest-onlyloan of $750 (= 0.75 * $1,000) and 25% by equityissued by the investing firm, giving the firm a $250

equity investment in the project. (Note that the firm could either issue stock or use existing cash for the equity portion of the investment.) Finally, consistent with corporate finance theory, assume that the firm will maintain its overall market value capital structure of 60% debt and 40% equity, in which case creditors and shareholders will con- tinue to require returns on debt and equity invest- ments of 7% (pretax) and 15%, respectively.7Based on the project's cash flows and the calcu- lated WACCas the appropriate discount rate, the NPV of the project's assets (NPVA)' which is the usual focus in a finance principles text, can be cal- culated as:

investment. However,NPVA should not differ fromNPVE since the NPV should not depend on the way in which it is calculated. Because the NPV of an investment is the value to be added to the invest- ing firm's market-value balance sheet, there can be only one true NPV.The explanation for this apparent inconsistency lies in a misunderstanding of the true debt-equity mix to finance the project if the firm is to maintain its overall market-value capital structure of 60% debt and 40% equity. Because the NPVA of $76.06 will be added to the value of the firm, this means that the implied debt-equity financing mix for the project is not the book-value 75%-25% mix but rather ($7501$1,076.06) = 69.70% debt and$1,076.06 - $750)/$1,076.06) = 30.30% equity."

Thus, to maintain its target capital structure of60% debt and 40% equity, the firm must actually issue debt in the amount of (0.60 * 1,076.06) =$645.64 and contribute equity (from issuing stockor using existing cash) in the amount of $1,000 -

$645.64 = $354.36 to cover the $1,000 net invest- ment outlay. (Adding the equity contribution of$354.36 and the NPVA of $76.06 gives a total eq- uity investment of $430.42, which is exactly 40%

Journal of Real Estate Portfolio Management 37Charles J. Delaney, Steven P. Rich, and John T. Roseof the $1,076.06 value of the project.) Given the15% required return on the equity investment, the true NPV of the equity investment (NPVE) can then be calculated as:NPV = $1,170 - $645.64 * [1 + 0.07(1 - 0.35)]E 1.15- $354.36 = $430.42 - $354.36= $76.06, (4)which equals the NPVA calculated above.Thus, regardless of whether one uses the finance approach or the real estate approach, the NPVof a proposed investment project is the same, pro- vided that the NPV calculation (1) uses the market values of the firm's debt and equity to calculate the firm's WACC as the discount rate for computing NPVA and (2) uses the implied market-value fi- nancing mix, rather than the book-value financing mix, of debt and equity to calculate the net cash flow for computing NPVE'ConclusionThe seemingly contradictory treatment of financ- ing costs in NPV analysis between principles of fi- nance and principles of real estate courses can be confusing for real estate students who must take both courses. Recognizing this problem, real estate textbooks should explicitly acknowledge the differ- ent treatment of financing costs across the two dis- ciplines. Further, real estate texts should explain (at least in general terms that a beginning student can understand) the equivalence of the two ap- proaches when one correctly uses the implied market-value debt-equity mix (which is necessary to maintain the firm's overall target capital struc- ture) to calculate the net cash flow for computing the NPV for the equity investor. Such a discussion would give students a better understanding of NPV in both finance and real estate and help them see that the analysis they learn in real estate for calculating NPV is entirely consistent with that taught in finance provided that the true financing mix is factored into the analysis.38 Vol. J 4, No. J, 2008

Endnotes1. For a discussion of the development of the academic disci- pline of real estate as an offshoot of finance and the link between the two disciplines, see Wurtzebach (1980).2. Though the focus here is on NPV analysis, specifically,the different treatment of financing costs between real estate and finance, the same issue arises in internal rate of return (IRR) analysis. Thus, reconciling the different calculations of NPV between real estate and finance will also reconcile the different calculations of IRR.3. It should be emphasized that the thinking here is of a real estate course offered as part of a rigorous real estate pro- gram within the business school of a four-year college or uni- versity. A real estate principles course taught as a profes- sional course to prepare students to sit for their sales license examination may not cover NPV analysis. For example, Ja- cobus (2006), which is written primarily to prepare the reader for the license examination, discusses the cash flow from a real estate investment but makes no mention of NPV analysis.4. The authors know of no academic literature and only one upper-level corporate finance textbook-Berk and DeMarzo (2007, pp. 585-88)-that addresses the difference between the finance and real estate disciplines' approach to NPV analysis. However,we know of no finance or real estate prin- ciples text that explores this issue.5. The eight books include Brealey et al. (2004), Gitman (2006), Keown et al. (2006), Megginson and Smart (2006), Moyer et al. (2006), Brigham and Houston (2007), Ross et al. (2007), and Block and Hirt (2008). Market shares are for the 2005-06 academic year and were provided by the publisher of one of these texts, based on data compiled by Monument Infor- mation Resource (MIR).6. For a discussion of the WACCas the appropriate cost of cap- ital for investment projects of comparable risk as the firm's existing assets, see Brealey et al. (2004, pp. 319-21, 333), Megginson and Smart (2006, pp. 431-32), and Ross et al. (2007, p. 375, 383). For a project of greater (lesser) risk than the firm's existing assets, the discount rate should then be adjusted upward (downward) relative to the WACC to rec- ognize the higher (lower) returns that would be demanded by debt and equity investors on such a project. The firm's WACe is inappropriate as the discount rate for any project of greater (lesser) risk than the firm's existing assets.7. Modigliani and Miller (1963) show that the required returns on debt and equity capital will vary with changes in the firm's capital structure. Specifically, if a firm increases its financial leverage, the cost of both debt and equity capital will rise. However,because of the tax benefit of debt, the net effect of the added leverage will be to reduce the firm's weighted average cost of capital. Thus, in the example, the7% (pretax) and 15% costs of debt and equity, respectively, apply only if both the firm's the capital structure and the risk of the firm's assets remain unchanged with the proposed investment project.8. It should be emphasized, however, that the implied debt- equity financing mix of 69.70%-30.30% applies to this in- vestment only, as another $1,000 project funded by a book- value financing mix of 75% debt and 25% equity, but with aFinancing Costs and NPV Analysis in Finance and Real Estatedifferent NPVA would have a different implied debt-equity financing mix.

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Journal of Real Estate Portfolio Management 39