Financing Costs and NPV Analysis in Finance and Real Estate

Delaney, 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 in

Finance and Real Estate
Executive 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 financing costs between finance and real estate textbooks, reconciles the difference, and recommends that real estate
textbooks explicitly address this issue to minimize students' confusion and to give them a better understanding
of NPV analysis.

by Charles J. Delaney*
Steven P. Rich**
John T. Rose***

Most collegiate schools of business require students 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 estate, necessarily overlaps with the principles of finance.! For example, both courses introduce students to the analytics of investing in real assets,
including the technique of net present value (NPV)
analysis." However, seemingly contradictory treatment of financing costs in NPV analysis across the
two disciplines can be confusing for real estate students 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 recommends 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 Financing

Costs in NPV Analysis

* Baylor University,
Delaneybaylor.edu.

Waco,

TX

76798-8004

**Baylor University, Waco, TX 76798-8004

baylor.edu.
***Baylor
University,
baylor.edu.

Waco, TX 76798-8004

or

Charles-

or Steve_Rich
or JT_Rose

While some finance textbooks explicitly address financing 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 abbreviated edition) account for nearly 80% of the introductory finance textbook market, revealed that
only four books-Brealey,
Myers, and Marcus
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35

Charles 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 mention financing costs in discussing NPV analysis."
But all four books are consistent in arguing (1)
that NPV analysis should focus on the total investment 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 required 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 necessary to calculate the WACC using the market
values of the debt and equity capital since investors' 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 calculated using debt and equity weights calculated
from market values rather than book values [e.g.,

36

Brealey et al. (2004, pp. 328-29), Ross et al. (2007,

p. 372), and Moyer et al. (2006, p. 408)]. In addition, 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 financing 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 expected from the project. In so doing, the analysis
focuses solely on the equity investment and the
projected cash flows, net of any principal and interest payments, to the investing firm (the equity
investor). As Ling and Archer (2008, p. 498) note,
"... in many cases, property owners use a combination 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 net
cash 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 equity

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Financing Costs and NPV Analysis in Finance and Real Estate

investment as the discount rate, as real estate

textbooks maintain?

Reconciling NPV Analysis

and Real Estate

NPVA

$1,170
1.0873 - $1,000

$1,076.06

- $1,000

$76.06.

(2)

in Finance

By contrast, in a typical real estate textbook example, the 75%-25% debt-equity financing mix
Consider a real estate investment firm with a would likely be factored directly into the analysis
market-value capital structure consisting of 40% by focusing on the equity investment and subtractequity and 60% debt, which is the firm's target (op- ing the debt service requirements from the extimal) capital structure. Assume further that the pected cash flow.In that case, the net cash flow to
firm's cost of equity and debt, as calculated from the equity investor would be $1,170 - $750 * (1 +
the market values of the firm's common stock and 0.07(1 - 0.35)), and the NPV of the equity investdebt outstanding, are 15% and 7% (pretax), re- ment (NPVE), which is the usual focus in a real
spectively, and that the firm's marginal tax rate is estate principles text, would likely be calculated
as:
35%. With this information, the firm's WACCcan
be calculated as:
NPV = $1,170 - $750 * [1 + 0.07(1 - 0.35)]
WACC

(0.15

+ (0.07
=

* .40)
* (1 -

0.0873.

1.15

0.35)

- $250 = $335.54 - $250 = $85.54.

0.60)
(1)

Assume now that the firm is analyzing a prospective 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-only
loan of $750 (= 0.75 * $1,000) and 25% by equity
issued 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 continue to require returns on debt and equity investments of 7% (pretax) and 15%, respectively.7
Based on the project's cash flows and the calculated 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 calculated as:

(3)

But this amount differs from NPVA> suggesting different NPVs for the project's assets and the equity
investment. However,NPVA should not differ from
NPVE 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 investing 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 of

60% 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 stock
or using existing cash) in the amount of $1,000 $645.64 = $354.36 to cover the $1,000 net investment outlay. (Adding the equity contribution of
$354.36 and the NPVA of $76.06 gives a total equity investment of $430.42, which is exactly 40%

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37

Charles J. Delaney, Steven P. Rich, and John T. Rose

of the $1,076.06 value of the project.) Given the

15% required return on the equity investment, the
true NPV of the equity investment (NPVE) can
then be calculated as:
NPV = $1,170 - $645.64
E

- $354.36
=

* [1 + 0.07(1 - 0.35)]
1.15

$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, provided 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 financing mix, rather than the book-value financing
mix, of debt and equity to calculate the net cash
flow for computing NPVE'

Conclusion
The seemingly contradictory treatment of financing costs in NPV analysis between principles of finance 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 different treatment of financing costs across the two disciplines. Further, real estate texts should explain
(at least in general terms that a beginning student
can understand) the equivalence of the two approaches when one correctly uses the implied
market-value debt-equity mix (which is necessary
to maintain the firm's overall target capital structure) 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

Endnotes
1. 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 program within the business school of a four-year college or university. A real estate principles course taught as a professional course to prepare students to sit for their sales license
examination may not cover NPV analysis. For example, Jacobus (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 principles 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 200506 academic year and were provided by the publisher of one
of these texts, based on data compiled by Monument Information Resource (MIR).
6. For a discussion of the WACCas the appropriate cost of capital 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 recognize 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, the
7% (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 debtequity financing mix of 69.70%-30.30% applies to this investment only, as another $1,000 project funded by a bookvalue financing mix of 75% debt and 25% equity, but with a

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Financing Costs and NPV Analysis in Finance and Real Estate

different NPV A would have a different implied debt-equity
financing mix.

References
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