introduction to discounted cash flow analysis
DESCRIPTION
Introduction to Discounted Cash Flow Analysis. by James R. DeLisle, Ph.D. March 18, 2014. Lecture Preview. DCF Prelude: Frontdoor /Backdoor. The Value Proposition: Value => Cost?. Value ??. Value = Income Rate. Land & Hard Costs. Known Soft Costs & Fee Costs. - PowerPoint PPT PresentationTRANSCRIPT
© JR DeLisle, Ph.D.
Introduction to Discounted Cash Flow Analysis
byJames R. DeLisle, Ph.D.
March 18, 2014
© JR DeLisle, Ph.D.
Lecture Preview
• The Value Proposition• Frontdoor/Backdoor Models
DCF Prelude
• DCF: A Visual Overview• One Word: GiNiTiBtAtNR• Basic Inputs
Introduction to Discounted Cash Flow
• Schedule 1: Pro Forma Cash Flow• Schedules II-III: Depreciation and Loan Amortization• Schedules IV-V: Capital Gain Taxes and Net Reversion• Schedules VI: Financial Ratios
DCF Schedules
DCF PRELUDE: FRONTDOOR/BACKDOOR
© JR DeLisle, Ph.D.
The Value Proposition: Value => Cost?
Land & Hard Costs
Unknown Fees
Known Soft Costs & Fee Costs
TRCm
Value = Income Rate
$’s Cost = Create Value
Value ??
TRCm = Total Replacement Cost market
© JR DeLisle, Ph.D.
FD/BD Value Proposition: Cost < >Value ?
Value * Rate = Income
Value
* Rate
Income
Frontdoor
Value * Rate => Income Value <= Income Rate
Backdoor
User
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Frontdoor Model: Sequence
Land
Hard & Soft Costs
TRCm
TRCm
NIr
* Wcc
/ NIR
GIr
NIR = 1 – (Er + Ptx + Vr)
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Backdoor Model: Reverse Engineered
Land
Hard & Soft Costs
TRCj
TRCj
NIm
/ Wcc
/ NIRGIm
Market
NIR = 1 – (Er + Ptx + Vr)
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Backdoor to Unleveraged DCF Analysis
Land
Hard & Soft Costs
TRCm
TRCm
NIm
/ Wcc
* NIRGIm
Market=
Ej
NIr
StabilizedNOI
Sales Price - Sales Exp- Tax on Sale- Mtg. Bal.
Net Reversion
PV C
F
+PV
NR
Frontdoor/Backdoor vs. DCF
Frontdoor/Backdoor
• Annuitized
• Leveraged/Unleveraged
• Constant Dollars– Before Tax– Before Sale
Discounted Cash Flow
• Non-annuitized
• Leveraged/Unleveraged
• Present Value (TVM)– After-tax– After Sale
DCF MODELS: A VISUAL PERSPECTIVE
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Equity Justified: PV of CF + PV Net Reversion
NIr
GIr
PV C
F
+
© JR DeLisle, Ph.D.
Net Reversion
TRCm
NIr
GIr
StabilizedNOI
Sales Price - Sales Exp
Net Reversion
Appreciation
Land Value
Depreciation
AmortizationMortgage
CG Appr x 15%
CG Depr x 25%
Pb
Net Sales Price
© JR DeLisle, Ph.D.
Equity Justified: PV of CF + PV Net Reversion
= Ej
NIr
GIr
Sales Price - Sales Exp - Tax on Sale - Mtg. Bal.
Net Reversion
PV C
F
+PV
NR
© JR DeLisle, Ph.D.
Cash Flow: The One Key Word
GI NI TI BT AT NR
Gross IncomeNet Income
Taxable Income
Before Tax Cash Flow
After Tax Cash Flow
Net Reversion
DCF CASE STUDY:INPUTS AND SCHEDULES
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Real Estate Fundamentals
© JR DeLisle, Ph. D.
Cash Flow Variables and TRC/FD/BD Inputs
Total Replacement Costs
Income & Expenses
Debt Assumptions
Income Taxes
Terminal Value
Equity Assumptions
Land ValueBuilding ValueTotal Replacement Cost
Gross IncomeVacancy LossExpensesProperty Taxes
Loan-to-ValueMortgage Interest RatePeriodicity (Payments/YearLoan term (years) Depreciable Life (R=27.5; C=39) Capital Gain Tax Rate on Appreciation Capital Gain Tax Rate on Value
Marginal Tax RateEquity discount rateReinvestment rate
LandV 435,600$ BldgV 3,436,567$ TRC 3,872,167$
GI, GIC $468,557VacR 10.00%
ExpR, ExpC 10.00%PTXr, PTxC 8.00%
LV 80.00%Mr 7.50%Ppy 12
Term 30
SellExp 2.00%Ce 10.00%
MTxR 36.00%Ec 10.00%RIr 6.00%
4.00%
4.00%3.00%
Value Assumptions Terminal Value Method (1=App, 2=Cap) 2Appreciation Rate 2%Exit Cap Rate 10.00%
Selling ExpenseExit Cap Rate
DeprLife 39CGTxR 15.00%CGTxV 25.00%
© JR DeLisle, Ph.D.
Discounted Cash Flow and Financial Ratios
• Schedule I: Cash Flow
• Schedule II: Depreciation
• Schedule III: Loan Amortization
• Schedule IV: Net Reversion
• Schedule V: Capital Gain Tax
• Schedule VI: Financial Ratios
© JR DeLisle, Ph.D.
Schedule I: Cash Flow Overview
Cash Flow ComponentGross Income Less: VacancyEffective Gross Income Less: Expenses Less: Property TaxesNet Operating Income Less: Depreciation Less: InterestTaxable Income Plus: Depreciation Less: Principal ReductionBefore Tax Cash Flow Less: Income Tax Due Plus: Tax SavingsAfter Tax Cash Flow Plus: Net Equity ReversionAfter Tax CF + Net Reversion
CodeGI
VacEGIExpPtxNI
DeprIntTI
DeprPrin
BTCFItax
TSOIATCF
NRATCF+NR
Year 1468,557(46,856)421,701(46,856)(37,485)337,361(88,117)
(231,362)17,88288,117
(28,556)77,443(6,438)
071,006
372,880443,885
Year 2487,299(48,730)438,569(48,730)(38,609)351,230(88,117)
(229,145)33,96888,117
(30,773)91,313
(12,229)0
79,084545,118624,202
Year 3506,791(50,679)456,112(50,679)(39,767)365,666(88,117)
(226,756)50,79388,117
(33,162)105,748(18,285)
087,463
687,712775,174
Year 4527,063(52,706)474,357(52,706)(40,960)380,690(88,117)
(224,181)68,39188,117
(35,736)120,772(24,621)
096,151
824,014920,166
Year 5548,145(54,815)493,331(54,815)(42,189)396,327(88,117)
(221,407)86,80388,117
(38,511)136,409(31,249)
0105,160968,091
1,073,252
© JR DeLisle, Ph.D.
Schedule I: Cash Flow OverviewSchedule I: Cash Flow
Year 1Gross Income 468,557 Less: Vacancy (46,856)Effective Gross Income 421,701 Less: Expenses (46,856) Less: Property Taxes (37,485)Net Operating Income 337,361
Cash Flow Component
Taxable Income 17,882 Plus: Depreciation 88,117 Less: Principal Reduction (28,556)Before Tax Cash Flow 77,443
Schedule II: DepreciationYear 1
Total Replacement Cost 3,872,167 Less: Land (435,600)Beginning of Year Tax Basis 3,436,567 Less: Depreciation (88,117) Plus: Capital ImprovementsEnd of Year Tax Basis 3,348,450 Plus Land 435,600Adjusted Basis 3,784,050Accumulated Depreciation 88,117
Schedule III: Loan AmortizationYear 1
Beginning of Year Balance 3,097,734 Mortgage Payment 259,918 Interest (231,362) Principal Reduction 28,556End of year balance 3,069,178
Schedule IV: After Tax After Sale ProceedsCash Flow Component Year 1Gross Sales Price 3,512,303 Less: Sales costs (70,246)Net Sales Price 3,442,057 Less: Capital Gain Tax on Appreciation 86,022 Less: Capital Gain Tax on Depreciation (22,029)Total Capital Gain (Tax) or Saving 63,993After Tax Sale Proceeds 3,442,057 Less: Mortgage Balance (3,069,178)Net Equity Reversion 372,880
Net Operating Income Less: Depreciation Less: InterestTaxable Income
337,361(88,117)
(231,362)17,882
Before Tax Cash Flow Less: Income Tax Due Plus: Tax SavingsAfter Tax Cash Flow
77,443(6,438)
071,006After Tax Cash Flow
Plus: Net Equity ReversionAfter Tax CF + Net Reversion
71,006372,880443,885
© JR DeLisle, Ph.D.
Schedule I: GI to NI
Cash Flow Component Year 1 Initial CalculationGross Income 468,557 = GIn
Less: Vacancy (46,856) = -(GIn * Vr)Effective Gross Income 421,701
Less: Expenses (46,856) = (-GIn * Er) Less: Property Taxes (37,485) = (-GIn * PTXr)Net Operating Income 337,361
Year 2 GIn-1 * (1+ RC) 487,299
(48,730)438,569
Expn *(1+ExC) (48,730)PTxn*(1+TTxC) (38,609)
351,230
Schedule I: Cash FlowYear 1 Year 2 Year 3 Year 4 Year 5
Gross Income 468,557 487,299 506,791 527,063 548,145 Less: Vacancy (46,856) (48,730) (50,679) (52,706) (54,815)Effective Gross Income 421,701 438,569 456,112 474,357 493,331 Less: Expenses (46,856) (48,730) (50,679) (52,706) (54,815) Less: Property Taxes (37,485) (38,609) (39,767) (40,960) (42,189)Net Operating Income 337,361 351,230 365,666 380,690 396,327
Cash Flow Component
© JR DeLisle, Ph.D.
Schedule II: Depreciation
Schedule II: DepreciationYear 1 Year 2 Year 3 Year 4 Year 5
Total Replacement Cost 3,872,167 Less: Land (435,600)Beginning of Year Tax Basis 3,436,567 3,348,450 3,260,333 3,172,216 3,084,099 Less: Depreciation (88,117) (88,117) (88,117) (88,117) (88,117) Plus: Capital ImprovementsEnd of Year Tax Basis 3,348,450 3,260,333 3,172,216 3,084,099 2,995,981 Plus Land 435,600 435,600 435,600 435,600 435,600Adjusted Basis 3,784,050 3,695,933 3,607,816 3,519,699 3,431,581Accumulated Depreciation 88,117 176,234 264,351 352,468 440,586
Schedule II: DepreciationComponent Year 1
Total Replacement Cost 3,872,167 Less: Land (435,600)Beginning of Year Tax Basis 3,436,567
$3,436,567*(1/39) = $88,117
Less: Depreciation (88,117) Plus: Capital ImprovementsEnd of Year Tax Basis 3,348,450 Plus Land 435,600Adjusted Basis 3,784,050Accumulated Depreciation 88,117
Year 2
3,348,450(88,117)
3,260,333435,600
3,695,933176,234
© JR DeLisle, Ph.D.
3,097,734 Pb1(3,069,178) - Pb2
28,556 Pr
Schedule III: Loan Amortization
Factor Code Initial PaymentCompounding/Period m 12Term t 30Present Value PV 3,097,734Payment PMT $21,660Future Value FV $0Interest Rate I 7.50%
#/yr 12Annual $259,918
Code Initial Prin Bal.m 12t 29
PV 3,069,178PMT 21,660FV $0I 7.50%
Amortization Year 1Beginning of Year Balance 3,097,734 Mortgage Payment 259,918 Interest (231,362) Principal Reduction 28,556End of year balance 3,069,178
259,918 Pmt(28,556) -Pr231,362 Int
Calculate Payment
Calc. Principal Balance
Calc. Prin.Reduction
Calc. Interest
© JR DeLisle, Ph.D.
Schedule III(b): Loan Amortization
Year 1 Year 2 Year 3 Year 4 Year 5Beginning of Year Balance 3,097,734 3,069,178 3,038,405 3,005,243 2,969,507 Mortgage Payment 259,918 259,918 259,918 259,918 259,918 Interest (231,362) (229,145) (226,756) (224,181) (221,407) Principal Reduction 28,556 30,773 33,162 35,736 38,511End of year balance 3,069,178 3,038,405 3,005,243 2,969,507 2,930,996
Schedule III: Loan Amortization
Amortization Year 1 Year 2Beginning of Year Balance 3,097,734 3,069,178 Mortgage Payment 259,918 259,918 Interest (231,362) (229,145) Principal Reduction 28,556 30,773End of year balance 3,069,178 3,038,405
© JR DeLisle, Ph.D.
DCF: NI to BTCFNet Operating Income 337,361
Less: Depreciation (88,117) Less: Interest (231,362)Taxable Income 17,882
Schedule II: DepreciationComponent Year 1
Total Replacement Cost 3,872,167 Less: Land (435,600)Beginning of Year Tax Basis 3,436,567 Less: Depreciation (88,117) Plus: Capital ImprovementsEnd of Year Tax Basis 3,348,450 Plus Land 435,600Adjusted Basis 3,784,050
Schedule III: Loan AmortizationYear 1
Beginning of Year Balance 3,097,734 Mortgage Payment 259,918 Interest (231,362) Principal Reduction 28,556End of year balance 3,069,178
Taxable Income 17,882 Plus: Depreciation 88,117 Less: Principal Reduction (28,556)Before Tax Cash Flow 77,443
Net Operating Income 337,361 351,230 365,666 380,690 396,327 Less: Depreciation (88,117) (88,117) (88,117) (88,117) (88,117) Less: Interest (231,362) (229,145) (226,756) (224,181) (221,407)Taxable Income 17,882 33,968 50,793 68,391 86,803 Plus: Depreciation 88,117 88,117 88,117 88,117 88,117 Less: Principal Reduction (28,556) (30,773) (33,162) (35,736) (38,511)Before Tax Cash Flow 77,443 91,313 105,748 120,772 136,409
Year 1 Year 2 Year 3 Year 4 Year 5Cash Flow Component
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Real Estate Fundamentals
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Schedule I: BTCF to ATCF
Before Tax Cash Flow 77,443 Less: Income Tax Due (6,438) Plus: Tax Savings 0After Tax Cash Flow 71,006
Taxable Income 17,882 Plus: Depreciation 88,117 Less: Principal Reduction (28,556)Before Tax Cash Flow 77,443
If TI > 0, -TI * MtxR
If TI < 0, TI * MtxR
17,882 TI
36% MtxR
(6,438) ITax0 TSOI
Before Tax Cash Flow 77,443 91,313 105,748 120,772 136,409 Less: Income Tax Due (6,438) (12,229) (18,285) (24,621) (31,249) Plus: Tax Savings 0 0 0 0 0After Tax Cash Flow 71,006 79,084 87,463 96,151 105,160
Year 1 Year 2 Year 3 Year 4 Year 5Cash Flow Component
© JR DeLisle, Ph.D.
Schedule V: Capital Gain on SaleYear 1 Year 2
Capital Gain Tax on ValueGross Sales Price 3,512,303 3,656,656 Less: Sales costs (70,246) (73,133)Net Sales Price 3,442,057 3,583,523 Less: Original Cost Basis 3,872,167 3,872,167Capital Gain on Appreciation (430,110) (288,644)
CGTax on Appreciation 86,022 57,729Capital Gain on Accumulated Depreciation 88,117 176,234
CGTax on Accumulated Depreciation (22,029) (44,059)Total Capital Gain (Tax) or Saving 63,993 13,670Capital Gain Tax 0 0Capital Gain Saving to other Cap Gains * 63,993 13,670* If value is positive (Saving) this can be used against outside gains from other assets in current year. If savings exceed outside gains, they will be carried over future years.
Schedule IV: After Tax After Sale ProceedsCash Flow Component Year 1 Year 2Gross Sales Price 3,512,303 3,656,656 Less: Sales costs (70,246) (73,133)Net Sales Price 3,442,057 3,583,523 Less: Capital Gain Tax 0 0After Tax Sale Proceeds 3,442,057 3,583,523 Less: Mortgage Balance (3,069,178) (3,038,405)After Tax Net Equity Reversion 372,880 545,118
Schedule III: Loan AmortizationYear 1 Year 2
Beginning of Year Balance 3,097,734 3,069,178 Mortgage Payment 259,918 259,918 Interest (231,362) (229,145) Principal Reduction 28,556 30,773End of year balance 3,069,178 3,038,405
Schedule IV-V: CGTaxes on Sale & AT ProceedsSchedule IV: AT Proceeds
Schedule V: Capital Gain Tax On Sale If, CapGain * 15%
AccDepr * 25%
© JR DeLisle, Ph.D.
Schedule I: Cash Flow 1- 10
Cash Flow Component Year 1 Year 2 Year 3 Year 4 Year 5Gross Income 468,557 487,299 506,791 527,063 548,145 Less: Vacancy (46,856) (48,730) (50,679) (52,706) (54,815)Effective Gross Income 421,701 438,569 456,112 474,357 493,331 Less: Expenses (46,856) (48,730) (50,679) (52,706) (54,815) Less: Property Taxes (37,485) (38,609) (39,767) (40,960) (42,189)Net Operating Income 337,361 351,230 365,666 380,690 396,327 Less: Depreciation (88,117) (88,117) (88,117) (88,117) (88,117) Less: Interest (231,362) (229,145) (226,756) (224,181) (221,407)Taxable Income 17,882 33,968 50,793 68,391 86,803 Plus: Depreciation 88,117 88,117 88,117 88,117 88,117 Less: Principal Reduction (28,556) (30,773) (33,162) (35,736) (38,511)Before Tax Cash Flow 77,443 91,313 105,748 120,772 136,409 Less: Income Tax Due (6,438) (12,229) (18,285) (24,621) (31,249) Plus: Tax Savings 0 0 0 0 0After Tax Cash Flow 71,006 79,084 87,463 96,151 105,160 Plus: Net Reversion 436,872 558,789 687,712 824,014 968,091After Tax CF + Net Reversion 507,878 637,873 775,174 920,166 1,073,252
Year 10666,903(66,690)600,212(66,690)(48,909)484,613(88,117)
(203,950)192,54688,117
(55,967)224,696(69,316)
0155,379
1,820,6411,976,020
INTRODUCTION TO DCF RATIOS:KEY FINANCIAL INDICATORS
© JR DeLisle, Ph.D.
Schedule VI: Financial Ratios
Schedule VI: Ratio Analysis
Debt Coverage Ratio Default Ratio Profitability Index Before Tax Cash on Cash After Tax Cash on Cash Implicit Cap Rate Gross Income Multiplier Net Income Multiplier (P/E) Payback Ratio (w/o sale) Modified Payback (w/o sale) NPV Equity (sold/year) IRR if Sold/Year Modified IRR if Sold/Year Marginal Rate of Return
Year 11.300.730.52
10.00%9.17%
10.00%7.50
10.419.17%9.17%
($370,901)-42.68%-42.68%
Year 2 Year 3 Year 4 Year 51.35 1.41 1.46 1.520.71 0.69 0.67 0.650.75 0.92 1.06 1.20
11.79% 13.65% 15.59% 17.61%10.21% 11.29% 12.42% 13.58%10.00% 10.00% 10.00% 10.00%
7.50 7.51 7.52 7.5310.41 10.41 10.41 10.41
19.38% 30.67% 43.09% 56.67%19.93% 32.42% 46.78% 63.17%
($194,013) ($62,124) $49,674 $153,266-5.52% 6.69% 11.96% 14.76%-4.96% 6.63% 11.25% 13.48%40.62% 24.19% 18.70% 16.64%
CodeDCRDRPIBTCFATCFICrGIMNIMPBMPBNPVIRRMIRRMRR
© JR DeLisle, Ph.D.
Schedule VI: Financial Ratios
NIn Net Income in nth YearE1 Initial Equity Investment
ATCFn After Tax Cash Flow in nth YearBTCFn Before Tax Cash Flow in nth Year
NRn Net Reversion in nth Year = After Tax Sales ProceedsMVn Market Value in nth Year = Gross Sales PriceGIn Gross Income in nth YearNIn Net Income in nth YearIRR Internal Rate of Return
MIRR Modified Internal Rate of ReturnPV Present ValueRR Reinvestment RateFV Future Value
Debt Coverage Ratio NIn / MtgPayment Default Ratio Sum (Exp +Property Tax + Mtg Payments)n / GIn
Profitability Index [(PV ((ATCF)1-n + PV (NRn))] / E1
Before Tax Cash on Cash BTCFn / E1
After Tax Cash on Cash ATCFn / E1
Implicit Cap Rate NIn+1 / MVn
Gross Income Multiplier MVn / GIn
Net Income Multiplier (P/E) MVn / NIn
Payback Ratio (w/o sale) Sum(ATCF/E1)1 ->n Modified Payback (w/o sale) Sum ATCF1-> n + Reinvested/E1
NPV Equity [PV (ATCF 1->n) + PV (NRn)] - E1
IRR if Sold/Year [PV (ATCF 1->n) + PV (NRn)]IRR = PV(E1)IRR
Modified IRR if Sold/Year [(FV (ATCF 1->n)RR ) + (FV (NRn)RR)]IRR = PV(E1)IRR
Marginal Rate of Return [(ATCFn + NRn) - (ATCFn-1 + NRn-1)] / (ATCFn-1 + NRn-1)
© JR DeLisle, Ph. D.
Real Estate Fundamentals
© JR DeLisle, Ph. D.
Debt Coverage Ratio
• Interpretation– DCR provides a measure of the safety of the mortgage position, indicates the
cushion between required payments and NOI.– DCR’s should normally be 1.2 or more
• Equation
$0
$100
$200
$300
$400
$500
$600
$700
1 2 3 4 5 6 7 8 9 10
Thousands
0
0.2
0.4
0.6
0.8
1
1.2
1.4
1.6
1.8
2
MtgPay NI DCR
Year 1 Year 2 Year 3 Year 4 Year 5 Debt Coverage Ratio 1.30 1.35 1.41 1.46 1.52
NIn / MtgPayment
DCR: 1.3 Target
© JR DeLisle, Ph.D.
Lecture Review
• The Value Proposition• Frontdoor/Backdoor Models
DCF Prelude
• DCF: A Visual Overview• One Word: GiNiTiBtAtNR• Basic Inputs
Introduction to Discounted Cash Flow
• Schedule 1: Pro Forma Cash Flow• Schedules II-III: Depreciation and Loan Amortization• Schedules IV-V: Capital Gain Taxes and Net Reversion• Schedules VI: Financial Ratios
DCF Schedules