Problem:
An investor is considering two projects, A and B.
Project A involves the purchase of a five year interest on a property for £600,000. He will then receive rent income from the property fixed for the five year period at the rate of £150,000 per annum, payable annually in advance. Management and maintenance costs are fixed at £14,000 per annum payable at the beginning of each year. At the end of the five year period the investor no longer has any interest in the property, with no further money changing hands.
Project B involves the purchase of an office block. The purchase price is £700,000. Rent is received annually in advance commencing at £50,000. This is increased each year in line with price inflation. The renter agrees in advance to buy the office block in five years' time for the original price increased in line with price inflation over the five years.
1) Assuming zero price inflation, calculate the internal rate of return (yields) on the projects A and B.
2) What price inflation rate has to be experienced for the two projects A and B to have the same internal rate of return?
Note: The internal rate of return (IRR) of an investment project is the discount rate that, when applied to its future cash flows, will produce a net present value (NPV) equal to zero.