© JR DeLisle, Ph.D. Introduction to Discounted Cash Flow Analysis by James R. DeLisle, Ph.D. March 18, 2014

© JR DeLisle, Ph.D.

Introduction to Discounted Cash Flow Analysis

byJames R. DeLisle, Ph.D.

March 18, 2014


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


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


FD/BD Value Proposition: Cost < >Value ?

Value * Rate = Income

Value

* Rate

Income

Frontdoor

Value * Rate => Income Value <= Income Rate

Backdoor

User


Frontdoor Model: Sequence

Land

Hard & Soft Costs

TRCm

TRCm

NIr

* Wcc

/ NIR

GIr

NIR = 1 – (Er + Ptx + Vr)


Backdoor Model: Reverse Engineered

Land

Hard & Soft Costs

TRCj

TRCj

NIm

/ Wcc

/ NIRGIm

Market

NIR = 1 – (Er + Ptx + Vr)


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

CF

+

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


Equity Justified: PV of CF + PV Net Reversion

NIr

GIr

PV C

F

+


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


Equity Justified: PV of CF + PV Net Reversion

= E

j

NIr

GIr

Sales Price - Sales Exp - Tax on Sale - Mtg. Bal.

Net Reversion

PV C

F

+PV

NR


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

© JR DeLisle, Ph. D.

Real Estate Fundamentals


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%


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


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


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


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


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


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


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


DCF: NI to BTCF

Net 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


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




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


If TI > 0, -TI * MtxR

If TI < 0, TI * MtxR

17,882 TI

36% MtxR

(6,438) ITax

0 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


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 Proceeds

Schedule IV: AT Proceeds

Schedule V: Capital Gain Tax On Sale If, CapGain * 15%

AccDepr * 25%


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)192,546

88,117(55,967)224,696(69,316)

0155,379

1,820,6411,976,020

INTRODUCTION TO DCF RATIOS:KEY FINANCIAL INDICATORS


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%

CodeDCRDRPIBTCFATCFICrGIMNIMPBMPBNPVIRRMIRR

MRR


Schedule VI: Financial Ratios

NIn Net Income in nth Year

E1 Initial Equity Investment

ATCFn After Tax Cash Flow in nth Year

BTCFn Before Tax Cash Flow in nth Year

NRn Net Reversion in nth Year = After Tax Sales Proceeds

MVn Market Value in nth Year = Gross Sales PriceGIn Gross Income in nth Year

NIn 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)




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


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

Documents

© JR DeLisle, Ph.D. Introduction to Discounted Cash Flow Analysis by James R. DeLisle, Ph.D. March 18, 2014