MARINE TOWER RENOVATION PROJECT Case Solution

BTIRRe & ATIRRe under Loan Alternative 2

            The second loan alternative has also been analyzed. The loan amount under the second loan alternative is $ 76500 which is equal to a loan to value ratio of 93.29%. The loan amount has been calculated taking 75% of the existing value of the property and the costs of renovation of $ 200,000. This is a higher loan amount as compared to the current and the loan alternative 1 therefore, the risk of leverage would also be high. All the other terms under this loan remain same. It is assumed here that the value of the property would increase by the amount of renovation costs. The before and after tax cash flows have been computed as shown in the excel spreadsheet and then the before and after internal rates of returns have been computed without and with renovation. . The BTIRRe and ATIRRe under the existing loan are 19.04% and 11.68% respectively however, under loan option 1 these are 66.47% and 53.79% respectively. The incremental ATIRRe is approximately 42.11%. This is much higher as compared to the 28.62% incremental ATIRRe under loan option 1. However, since the returns are higher the risk of this financing alternative would also higher which is analyzed below.

Risks with Loan Alternatives

            The difference in the returns between loan alternative 1 and loan alternative 2 is due to the difference in the loan to value ratio as all the other loan inputs remain same. Therefore, as the loan to value ratio is increased, the loan amount is also increased. The renovations would be then financed through external loan rather than the equity investment which is even more risky. However, if the loan amount keeps on increasing keeping all the other things constant then the risk of leverage increases. The main reason for this is that the office building of Rambo might not generate enough cash flows in future in order to pay for the outstanding obligations.

            This risk could be checked by the debt coverage ratio for the loans which is calculated as net operating income divided by the debt service level in each year. The debt coverage ratio has been computed for the existing loan, loan alternative 1 and the loan alternative 2. The calculations could be seen in the excel spreadsheet. If we look at these ratios then it is clear that the current loan has the higher debt coverage ratio which increases each year with the growing net operating income. However, the loan alternative 2 has the lower debt coverage ratio which also increases since the NOI is increasing in each year. Therefore, the risk is higher in loan alternative 2 but it also has the highest return on equity as the amount of contributed equity has decreased.

Recommendation

            Despite the fact that the risk or leverage is higher under the loan alternative 2, but the returns are significantly higher if Rambo undertakes the renovation. Therefore, I would like to advice Rambo to think in terms of risk and return. If Rambo has a profile of a risk taker then he should renovate the office building by taking the loan alternative 2. I also recommend Rambo to use the loan alternative 2. This is because the debt coverage ratio is although less than 1 in year 1 but it would increase in the future years and till the time of the sale of the office building this ratio would be about 1.32 which is a moderate ratio. Therefore, I would advice Rambo to take loan 2 and renovate the building to enhance its value………………

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