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10 Old Grimsbury Rd, Banbury OX16 3HG, UK

BFA503 – Introduction to Financial Management

Solution:

Question 1:

The house taken for the project is 6 Hatchery Court, West Hobart, Tas 7000 having a value of $ 1.4 million. The house is located in one of the finest locations of West Hobart in Tasmania. The following is the information of the house related to the bedroom, facilities, bathrooms, etc.

  • The property is located at a location with mesmerizing mountain views and modern convenience at each turn.
  • The property is exuding luxury and sophisticated which is built with the highest standards and having extensive glazing and clerestory windows showcases having majestic views.
  • The house has an open-plan living space with an exclusive view and combined dining in which lighting is natural and provides a feeling of an effective natural environment (Wu, & Hou, 2021).
  • The house has an ultra-contemporary kitchen having all-new AEG appliances and having wide space for storage such as a walk-in pantry, quality cabinetry, and countertop space.
  • The accommodation has four bedrooms with carpets and effective sunshine and having three walk-in wardrobes, and each bedroom has an impressive view of the mountain.
  • The accommodation also has three bathrooms styled with charcoal floor ceiling tiles, walk-in glass showers, and a deep, free-standing tub.
  • The house has also additional facilities of a double garage and outdoor Jacuzzi and also has large workshop space.

Question 2:

Details of Comparable House Prices
AddressBed-roomsFloor space (m^2)Last sale dateLast sale price
6 Hatchery Court, West Hobart4948 m^2  
64 Forest Road West Hobart4705 m^225th September 2021$ 1.3 million
12 Thelma Drive, West Hobart32058 m^214th September 2021$ 1.9 million
172 Forest Road, West Hobart4636 m^218th October 2021$ 1.73 million
Valuation of the average value of property  (1.3/705 + 1.9/2058 + 1.73/636) / 3 * 948$ 1.73 million

(Dungey, Yanotti, & Wright, 2018)

The value of the property is considered as $ 1.4 million while the average value of the property is $ 1.73 million. The property value is estimated based on the near location and other facilities such as nearby schools and child care facilities and also based nearby community. Therefore it is estimated that the value of the property is $ 1.4 million for the above-mentioned property. The sources of the valuation and estimation are based on the real estate agents’ report on the nearby locality and valuation reports provided by the real estate agents.

Question 3:

The annual rental revenue from the property as mentioned above is estimated based on the comparable property rental value in the nearby locations and properties facilities available. The details of comparable properties and rental applicable on the properties are as follows:

Properties addressFacilitiesRent per weekRent per year
2/76 Barrack Street, Hobart4 bedroom, 3 bathroom, 2 car garage$ 700 per week$ 36,400 per annum
6/1 Collins Street, Hobart4 bedroom, 3 bathroom, 3 car garage$ 800 per week$ 41,600 per annum
7 Paternoster Row Hobart3 bedroom, 2 bathroom, 2 car garage$ 600 per week$ 31,200 per annum
Average rent  $ 36400 per annum

(Booth, & Kendal, 2020)

Based on the above information and average rent from the above properties it can estimate that the annual rental revenue income from the property is $ 39000 per annum (750 per week) due to other facilities also such as the outdoor Jacuzzi.

Question 4:

The property is situated in a good community place in Hobart and also there are various basic facilities available nearby the location of the property. If the property is let out to another person then there is a certain cost that the owner needs to incur and it is the liability of the owner to incur these expenses. The annual rental costs of leasing a home are as follows:

ParticularsCost
Land tax$ 975 per annum
Annual maintenance cost$ 2000 per annum
Cost of duties and other property taxes$ 2250 per annum
Electricity, water, and heating expenses$ 2000 per annum
The total cost incurred for leasing property$ 7225 per annum

The cost incurred by the owner is based on the rental agreement made between tenant and owner. As the urgent repair work is conducted by the tenant and reimbursed by the owner to the tenant (Wong, & Wakefield, 2017). The water consumption bill is paid by the owner and charges a fixed amount from the tenant which includes in the rent amount.

Question 5:

The locality of Hobart at where the property is situated high in demand for several businessmen and industrialists for their employees and other executives. As per the records of the government statistics agency, the properties occupied in Hobart are 65% by owner-occupied households and 34% by renter-occupied households. Based on the continuous increase in demand for property by tenants, it is estimated that there will be an increase in rent by the growth rate of 8%.

The demand has increased due to high rates of employment growth in Hobart, population growth, and an increase in house prices. There is high growth in the housing market in Tasmania and an increase in the housing price growth. The report of the government states that there is an annual increase in the visitors by 8% and based on which it is estimated that there is a growth rate of 8% in the rental income per annum.

Question 6a:

The required rate of return is based on the cost incurred by the owner for the acquisition of property using personal savings, debt, and other financing factors. The required rate of return is always higher or equal to the cost of financing the property. The estimated required rate of return of property based on the debt and opportunity cost on savings is 10.31%. The estimated rate is taken based on the statistics of the government and the financing rate charged on the property.

Using the perpetuity with growth formula, the estimated value of property is as follows:

Gross rental income              =          $ 39000

Less: Leasing cost                   =          $ 7225

Net rental income                  =          $ 31775

Growth rate                            =          8%

Rate                                        =          10.31%

Estimated value of property =          $ 31775 / (10.31% – 8%)         =          $ 1375541

Therefore, based on the rental income, the property has a value of $ 1.4 million and it is feasible to pay such value for the property.

Question 6b:

The perpetuity method used above provides value near the price of a property in the market. However the perpetuity method is not suitable for valuing the house as the useful life of the property, major cost incurred in future such as innovation of property, replacement, and re-furnishing of property which cause of the high amount of outflow of funds and also adjustment in the required rate of returns as the required rate of returns is based on the interest rate charged on the loan taken for property, opportunity cost bear by the owner on investment of savings in the property (Zakharkina, & Abramchuk, 2018). It is estimated that the useful life of the property is 50 years and there are major expenses of $ 400000 incurred after 25 years for re-furnishing and renovation of property based on which the value of the property is as follows:

Valuation of the required rate of return:

It is estimated that the owner has 50% amount of property in savings on which the owner earn 7% return and 50% amount taken on loan on which the applicable interest rate is 9.5% based on which the required rate of return is:

r           =          0.07 * 0.50 + 0.095 * 0.50      =          8.25%

The value of the property on the above mentioned rated and considering the outflow and useful life of property:

Present value of net rental income              =          $ 1.39 million

Less: Cash outflow at the end of 25th Year   =          $0.06 million

Estimated value of property                         =          $ 1.33 million

Question 7a:

The current inflation rate in Tasmania and Australia is 1.8% and 1.6% respectively. The information is taken from the report provided treasury related to consumer price index as of 28th July 2021 and data taken related to June Quarter 2021.

The percentage and weighted of CPI components in the consumer price index based on the report is as follows:

Based on the above information, the weight of housing, food, health, education, and transport in Australia, the weighted average inflation calculation is as follows:

 Australia  
ComponentInflation rateWeightInflation rate * weight
Food0.730%0.21
Housing-0.25%-0.01
Health4.825%1.2
Transport10.735%3.745
Education3.75%0.185
Weighted average inflation rate5.33

Question 7b:

The inflation rate calculated based on the weighted average of components in Australia’s consumer price index is 5.33% which is lower as compared to the required rate of return. The required rate of return is 8.25% and higher than the inflation rate due to other factors also such as the demand and supply of houses in Tasmania. Tasmania has high housing component inflation rate that impacts the required rate of return on the property. There is a 1.7% consumer price index in housing and a high weight allocated to the housing sector as an increase in the housing market in Tasmania. The education’s price index is also higher in Tasmania as compare to Australia that also impacts the required rate of return on the property.

Question 7c:

The growth rate estimated above is 8% which is higher than compare inflation rate i.e. 5.33%. The rate is feasible based on the consumer price index in Tasmania as high housing inflation rate, high education inflation rate, high food inflation rate which are basic requirements. The high inflation rate in Tasmania has an impact on the growth rate of rent therefore the growth rate estimated is accurate and feasible with the inflation rate in Tasmania.

Question 8a:

The current government bond yield in Australia is 1.502% based on the 10 years bond. The information has been taken from the treasury report provided by the government and the bond rate prescribed in the market (Finlay, Seibold, & Xiang, 2020). Based on the domestic bond rate of Tasmanian Public Finance Corporation, the bond yield in Tasmania is 4%.

Question 8b:

The implied required rate of return is 8.25% while the government bond yield based on the domestic bond yield of Tasmania is 4% therefore the required rate of return is higher as compared to the bond yield. Therefore the owner is required to rent out the property in place of investment on government bonds.

Question 9a:

The most competitive home loan interest rate in the Australian Market for the purchase of a house in Tasmania is as follows:

Type of home loansThe provider or financial instituteHome loan interest rate
Home advantage packageHeritage bank3.06% per annum
Standard Variable loanANZ bank3.78% per annum
Base variable rate home loanNAB bank3.04% per annum
Extra Home loanCommonwealth Bank3.14% per annum

The above-mentioned rates are observed based on the results of the June 2021 quarters.

Question 9b:

Based on the above home loan rates, the required rate of return is higher than the loan interest rates. As the home loan interest rate is within 3% to 4% while the required rate of return is 8.25% which is much higher than the interest rates of home loans. The owner has taken a high interest rate due to investment involved long-term period and the interest rates include variable components also that may cause the increase in the interest rate in the following period.

Question 10a:

The ‘CAPM market’ required total return of the share market index in Australia is calculated based on the following formula:

Total return = Risk free return + beta * market risk premium

The risk-free return is the yield of government bonds which is 1.508% and the beta of the market is always 1. The market risk premium based on the Australian Energy Regulators is 6%. Therefore the required total return of the share market index in Australia is:

Total return = 1.508% + 1 * 6% = 7.508%

Question 10b:

The implied rate of return is high as compare to the total return on a market index as the market index has systematic risk and diversification of investment. While in the investment in housing property and earn rental income has various unsystematic and systematic risks involved which cannot eliminate as there is no diversification of investment (Pawson, 2018). The property investment has the risk of a vacant home, decrease in demand by the tenant in long-term period and decrease in the housing market in Tasmania as high fluctuation in demand and supply of houses.

Question 11a:

The price-earnings ratio of the house is calculated as follows:

Estimated cost of property                           =          $ 1.4 million

Annual rental earnings or net rental income          =          $ 31775 per annum

Price-earnings ratio    =          $1400000 / $31775    =          44 times

The price-earnings ratio is higher and also increase the risk for owner related to returns.

Question 11b:

Based on the S&P 500 market index of Australia the price-earnings ratio of the Australian market is 36 times. The information is taken as per information provided at yahoo finance.

Question 11c:

The price-earnings ratio of the house property is high as comparing the market index price-earnings ratio. Based on the ratio, the cost of property is higher as compared to the market and the risk involved in the house property is higher as compared to the market index.

Question 12a:

Negative gearing is the type of financial leverage in which the investors borrow money from the market or financial institutes and invest the amount in income-producing investment and the gross total income of investment is less than the cost of borrowing. The negative gearing is beneficial as the loss incurred investment can be offset with other income and helps in reduce the total tax liability of the investors (Montani, 2017).

For example, in this case, the property is purchased by the investor by taking a home loan from banks at the minimum interest rate i.e. 3.04%, and earn rental income at the rate of 2.26%. There is negative gearing as the loan is taken from the bank for the purchase of a house has a high cost as compared to income earned from house property by giving the property on lease to another person.

Question 12b:

The shares can be negatively geared if the return on shares investment is less than the cost incurred by the investor on the loan taken for an investment in shares. For example, the investor has taken a loan at the interest rate of 7% and the return on shares earned per annum is 5% then there are shares under negative gearing.

Question 13a:

The three main non-pecuniary benefits of homeownership over renting are as follows:

  • Homeownership reduced the burden of continuous change in living places and residential homes.
  • The owner can change and modify the property as per their needs and requirements and there is no need to change residence for change in requirements.
  • The ownership of property provides self-satisfaction and also reduces tensions of home accommodation requirements as it provides a feeling of security (Ojo, & Rotowa, 2017).

Question 13b:

The three main non-pecuniary benefits of renting a home over homeownership are as follows:

  • There is the flexibility of change in the locality as if the locality is not appropriate then the tenant can shift to other places easily.
  • The responsibility of repair, maintenance, and other construction work is held by the owner and the tenant is free from any responsibility of home.
  • The house property taken on rent is fully furnished and ready to move while in homeownership there is modification and construction required.

Question 14:

The strategy adopted when it is certain the price of real estate is going to fall in the next 6 months then in such case, the owner must sell the property and invest the amount in different investments such as market index and bonds. The effective strategy is sale the house property and invests an amount in diversified investment assets.

References:

Booth, K., & Kendal, D. (2020). Underinsurance as adaptation: Household agency in places of marketization and financialization. Environment and Planning A: Economy and Space52(4), 728-746.

Dungey, M., Yanotti, M. B., & Wright, D. (2018). Who, what, where? residential property investment in Australia.

Finlay, R., Seibold, C., & Xiang, M. (2020). Government bond market functioning and COVID-19. RBA Bulletin, September, 11-20.

Montani, D. (2017). Negative Gearing: Separating fact from fiction. Taxation in Australia51(8), 432-435.

Ojo, B., & Rotowa, O. O. (2017). The Role of the Federal University of Technology, Akure Cooperative Multipurpose Society in Housing Finance. Nigerian Journal of Environmental Sciences and Technology (NIJEST) Vol1(2), 349-354.

Pawson, I. (2018). Reframing Australia’s housing affordability problem: The politics and economics of negative gearing. Journal of Australian Political Economy, The, (81), 121-143.

Wong, P., & Wakefield, R. (2017). The Australian Residential Property Market: A Study on Foreign Real Estate Investment. EPiC Series in Education Science1, 165-178.

Wu, H., & Hou, H. C. (2021). An investigation of private-owner-led heritage property adaptive reuse.

Zakharkina, L. S., & Abramchuk, M. Y. (2018). Correctness of the CAPM-Model application in the Ukrainian reality in terms of investors’ financial security.

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