A property could be sold today for $2 million. It has a loan balance of $1 million and, if sold, the investor would incur a capital gains tax of $250,000. The investor has determined that if it were sold today, she would earn an IRR of 15% on equity for the past 5 years. If not sold, the property is expected to produce an after-tax cash flow of $50,000 over the next year. At the end of the year, the property value is expected to increase to $2.1 million, the loan balance will decrease to $900,000, and the amount of capital gains tax due is expected to increase to $255,000. a. What is the marginal rate of return for keeping the property one additional year? b. What is the decision to make by the investor?

a. What is the marginal rate of return for keeping the property one additional year?

1.82

b. What is the decision to make by the investor?

the investor should keep the property one more year since the returns generated by doing so are much higher than the returns the investor requires.

Explanation:

the current gains from selling the property = selling price - loan balance - capital gains tax = $2,000,000 - $1,000,000 - $250,000 = $750,000

if he investor keeps the property for one more year, h/she can earn = selling price - loan balance - capital gains tax + after tax cash flow = $2,100,000 - $900,000 - $255,000 + $50,000 = $955,000

marginal return from holding the investment one more year = $955,000 - $750,000 = $205,000

marginal cost = net investment x IRR = $750,000 x 15% = $112,500

marginal rate of return = $205,000 / $112,500 = 1.82