You are interested in investing in a building costing 10,000,000.

You can either finance the purchase of the building using either:

> Mortgage A and a 40% loan-to-value ratio; or

> Mortgage B and a 50% loan-to-value ratio.

Further details regarding the mortgages are provided in Table 1

You require an 8% return on an unlevered equity investment.

You anticipate receiving 1,000,000 in rental income at the end of every year for five years.

You plan to sell the building after five years for 11,000,000.

Table 1: Mortgage details.

Mortgage A Mortgage B

Interest rate per annum 5% 5%

Compounded Annually Annually

Payment frequency Annually in arrears Annually in arrears

Type Interest-only Constant payment

Loan-to-value ratio 40% 50%

Term (years) 5 5

Question 1

1.1 Assuming that Mortgage A is selected, calculate the levered cost of equity.

1.2 Assuming that Mortgage B is selected, calculate the levered cost of equity.

Question 2

2.1 Assuming that Mortgage A is selected, calculate the net present value of the investment. Use the cost of equity that you calculated in Question 1.1 as the appropriate discount rate. Round your calculated answer to the nearest pound.

2.2 Assuming that Mortgage B is selected, calculate the net present value of the investment. Use the cost of equity that you calculated in Question 1.2 as the appropriate discount.

2.3 Based on your answers in 2.1 and 2.2, state which mortgage you would choose, and justify your answer.

2.4 Now, assume that the net present value of the investment is identical with either mortgage (i.e. ignore your answers to 2.1 and 2.2). What would the advantage be of opting for Mortgage A?