CAPITAL BUDGETING ANALYSIS REPORT TO LAM

REGARDING POTENTIAL INVESTMENT OPPORTUNITY

Presented by:

GRETA BANYTE

This 34,722 square foot apartment building includes 60 units:

• 4 bachelor units,

There is also on-site laundry and parking with 60 available spaces.

Currently the price of the rent is:

• Income from the rent on all 3 types of units (“Bachelor units”, “Singles”, and “1+1”) will increase by 2% per year, while the income from laundry will remain unchanged.

In this case the expected monthly rent from each type of unit and expected monthly income from laundry would be:

• • Value of the land: 55% ($3,135,000)

  • Value of the building: 45% ($2,565,000)

• • $855,000 will be paid by LAM in cash.

• Loan of $4,275,000 (75% of the total listed property price):

  • Loan from Japanese bank: $2,137,500 (or ¥200,174,951):

    • Rate: 3%

• Capital gain tax rate will be 34% (note: in California corporate capital gains are taxed the same as regular income).

• Exchange rate: US dollar will appreciate by 1% against Japanese Yen in the beginning of 2011 (as of April 10^th 2010, the exchange rate: 1USD = 93.6491 Japanese Yen)

In the following table “Tax Analysis” you can see how tax expenses, associated with the project, are calculated. You can see that depreciation and interest paid on loans lower the taxable income and, thus, lessen LAM’s income tax expense. This has an effect on the project’s cash flow from operations: as the tax expense decreases – cash flow from operations increases.

In the table “Income Analysis” the tax expense on net income is reflected.

Where:

• R_e - expected rate of return on equity, or cost of equity

• R_d - expected borrowing rate, or cost of debt

To compute the cost of equity the CAPM will be used. According to the model, the expected cost of equity (Re) is equal to:

I will calculate the cost of equity in two ways: using the risk-free rate and expected return on the market in USA and Japan. As LAM is located in USA, I will assume the company’s beta to be equal to the average beta of comparable US REIT companies. The data is provided in the table below.

• Japan: E(R_e) = 0.13% + 1.60(7.2% - 0.13%) = 11.44%

Thus, according to CAPM, the expected return on the equity is 19.42% in USA and 11.44% in Japan.

As the project is assumed to be financed with 10% equity, 10% preferred stock and 80% debt, the WACC of the project is expected to be:

• Applying the cost of equity of 19.42% using the information from US market:

In both cases, the weighted average cost of capital varies within narrow range, from 3.76% to 4.55%. To calculate the net present value (NPV) of the project the average discount rate of 4.16% will be used:

• Applying the average cost of equity of 15.43% [= (19.42% + 11.44%) / 2]:

• Case 2: 5% decrease in Gross Operating Income: IRR = 10% NPV = $437,675

• Case 3: 5% increase in Operating Expenses: IRR = 15% NPV = $786,701

As you can see, the increase in Gross Operating Income, decrease in Operating Expenses and appreciation of US dollar against Japanese Yen would cause the project’s IRR and NPV to increase. On the other hand, the decrease in Gross Operating Income, increase in Operating Expenses and depreciation of US dollar against Japanese Yen would cause the project’s IRR and NPV to decrease.

For more detailed calculations, please, look at the Excel sheet named “Sensitivity Analysis”.

If we assumed that US dollar will appreciate against Japanese Yen by 1% every year, then the expected exchange rate would be:

This would have an impact on loan repayment to Japanese bank, as assumed the payments are made in Japanese Yen. If US dollar appreciated against Japanese Yen, LAM would need less US dollars to pay the principal and interest on the Japanese loan. It means that the net cash flow generated from the project would increase. As you can see from the table below, the project’s total cash flow would be:

Other way to hedge the exchange rate risk is to look for other sources to obtain Japanese Yen that could be used to repay the loan to Japanese bank. In this way, cash inflow in Japanese Yen would offset cash outflow in Japanese Yen.