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

Genaro must take into account both anticipated capital gains and rental income when calculating the maximum price he should pay to purchase the property. 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. The capital gain would equal 33% (50,000/$150,000) and the remaining 7% would be from rental income.

This information can then be used to calculate the expected return in present-day value using DCF analysis. If Genaro wants to earn a 40% annualized return, how much should he pay today for the property? If Genaro is using a 10% discount, our DCF calculations would indicate that Genaro shouldn’t pay $71,142 ($50,000+ 0.07×1.101×25,000). This represents an intrinsic value that Genaro can enjoy both capital gains and income from rental rentals over the course of his ownership period.