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Case Analysis 1 Write-Up revised

Financial Management (Howard University)

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Case Analysis
Time Value of Money: The Buy Versus Rent Decision
Write-Up

Andre' Diggs
Kamesia Hawkins
Wesley Jackson
Natasia Kennedy
Brooke Thomas

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Overview

The case describes Rebecca Young, who completed her MBA in May 2013 and moved to
Toronto to start a new job in investment banking She rented a two-bedroom condo for $3,000 per
month that included parking but not utilities or cable television. In July 2014, an identical unit
next door became available for sale, and Rebecca could purchase it for $500,000.00. Even
though she liked the condo, Rebecca planned to move to a house or larger penthouse condo
within 5 to 10 years. She's facing a tough dilemma on whether to continue renting or purchase a
new house or condo according to her future plans. While friends and family make compelling
arguments to both perspectives, Rebecca will have to perform a time value of money analysis to
support and confirm her decision to buy or rent.

Financial Background/Details

If Rebecca decided to purchase a new condo, she would have to consider the following financial
expenses:

1) $1,055.00 per month in condo fees

2) $300.00 per month in property taxes

3) $600.00 a year in maintenance and repairs ($50.00 per month)

4) $100,000.00 in a 20% cash down payment

5) $1,500.00 in 3.0% combined 1.5% local and 1.5% provincial deed-transfer taxes

6) $2,000.00 closing fees

In order to finance the remaining 80.0% of the purchase price, Rebecca contacted lenders
who would offer a 3.75% annual rate locked in for a 10-year terms, and she would amortize the
mortgage over 30 years with monthly payments. The money Rebecca planned to use for her
down payment and closing costs was invested and earning the same effective monthly rate of
return as she would be paying for her mortgage. She assumed that if she were to sell her condo in
the next 2 to 10 years, Rebecca would pay 5.0% of the selling price to realtor fees plus $2,000.00
in other closing fees.

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Scenario Analysis Background/Details

To complete a financial analysis of the buy-versus-rent decision, Rebecca would have to

perform the following steps:

1) Determine the required monthly payments.

2) Determine the opportunity costs (on a monthly basis) of using the lump-sum required funds
for the condominium purchase rather than leaving those funds invested and earning the effective
monthly rate.

3) Determine additional monthly payments required to purchase the condo compared to renting,
including opportunity cost.

Rebecca also wanted to consider what might happen if she chose to sell at a future date,
which would not transpire for at least two years but could in 5 or 10 years. She would model the
amount of the outstanding principal at various points in the future - two, five, or 10 years from
now and then determine the future gain or loss after 2, 5, and 10 years under the following
scenarios:

A) The condo price remains unchanged.

B) The condo price drops 10.0% over the next 2 years, then increases back to its purchase price
by the end of five years, then increases by a total of 10.0% from the original purchase price by
the end of 10 years.

C) The condo price increases annually by the annual rate of inflation of 2.0% per year over the
next 10 years.

D) The condo price increases annually by an annual rate of 5.0% per year over the next 10 years.

Although the majority of her decision would be based on a quantitative analysis, Rebecca
would also have to factor qualitative scenarios that would aid her in her decision to buy or rent.

Financial Analysis

With a purchase price of $500,000.00, an annual rate of 3.75%, 20.0% down payment of
$100,000.00, and amortization period of 30 years, Rebecca's monthly payment is $1,845.89. If
she decided to buy the identical condo, she would have to add monthly condo fees at $1,055.00,
taxes at $300.00, and repairs at $50.00, which would result in $3,250.89 per month. Compared to
monthly rent of $3,000.00, Rebecca's net additional payments are $250.89 per month. Her
monthly opportunity costs (down payment and closing costs) would be $362.80 if the
$117,000.00 was invested at the same rate of return. The total additional monthly cash flow cost

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is $613.69. Rebecca's principal outstanding after 2, 5, and 10 years is the following:

$384,936.59, $360,135.11, and $312,132.28. if Rebecca stopped her analysis at this point, it
would best for her to rent than buy because she would have to pay $250.89 more per month in
additional payments, and the total additional monthly cash flow cost would be $613.69. however,
we would have to include the scenario analysis for Rebecca to either rent or buy.

Financial Scenario Analysis

Scenario A) No Change in Price

2 years 5 years 10 years

Selling Price 500000 500000 500000
Realtor Fees (@5%) 25000 25000 25000
Other Selling fees 2000 2000 2000
Princ OS $384,936.59 $360,135.11 $312,132.28
Net Proceeds $88,063.41 $112,864.89 $160,867.72

Funds at Closing 117000 117000 117000

Opportunity Cost of Extra Payments Incl. Funds Used at Initial Closing $15,266.04 $40,401.14 $89,049.69

Net FV -$44,202.63 -$44,536.25 -$45,181.97

PV of Future Net (NPV) -$41,037.19 -$36,986.01 -$31,161.10

In this scenario, Rebecca's NPV would be in the negative after 2 (-$41,037.19), 5 (-$36,986.01),
and 10 years (-$31,161.10). Even though the NPV increases after 5 or 10 years, it still remains in
the negative. Rebecca would have to remain in the condo longer than 10 years based on the
model in this scenario in hopes of receiving a positive NPV; however, we're not confident that if
she remained longer than 10 years that there would be a positive NPV.

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Scenario B) 10.0% Down After 2 Years, Back to $500,000.00 After 5 Years, Up 10.0%
After 10 Years

2 years 5 years 10 years

Selling Price 450000 500000 550000
Realtor Fees (@5%) 22500 25000 27500
Other Selling fees 2000 2000 2000
Princ OS $384,936.59 $360,135.11 $312,132.28
Net Proceeds $40,563.41 $112,864.89 $208,367.72

Funds at Closing 117000 117000 117000

Opportunity Cost of Extra Payments Incl. Funds Used at Initial Closing $15,266.04 $40,401.14 $89,049.69

Net FV -$91,702.63 -$44,536.25 $2,318.03

PV of Future Net (NPV) -$85,135.62 -$36,986.01 $1,598.70

In this scenario, Rebecca's NPV would remain in the negative after 2 (-$85,135.62) and 5 (-
$36,986.01) years. Even though it significantly increases when you compare the NPVs after 2
and 5 years; however, they still remain negative. The NPV becomes positive after 10 years still
the amount is $1,598.70, but it is significantly low.

Scenario C) Condo Price Increases 2.0% Annually

2 years 5 years 10 years

Selling Price 520200 552040 609497
Realtor Fees (@5%) 26010 27602 30475
Other Selling fees 2000 2000 2000
Princ OS $384,936.59 $360,135.11 $312,132.28
Net Proceeds $107,253.41 $162,303.28 $264,890.07

Funds at Closing 117000 117000 117000

Opportunity Cost of Extra Payments Incl. Funds Used at Initial Closing $15,266.04 $40,401.14 $89,049.69

Net FV -$25,012.63 $45,303.28 $147,890.07

PV of Future Net (NPV) -$23,221.42 $37,623.00 $101,996.81

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In this scenario, if the condo price increases 2.0% annually, Rebecca's NPV is negative
after 2 years; however, it is positive after 5 and 10 years. When you compare the NPVs, there is a
$60,844.42 increase between 2 (-$23,221.42) and 5 years ($37,623.00). If Rebecca decided to
stay in the condo after 10 years, her NPV would increase by 2.71 times when comparing them in
5 years and 10 years. After 5 years, her NPV is $37,623.00, and 10 years, it would be
$101,996.81.

Scenario D) Condo Price Increase 5.0% Annually

2 years 5 years 10 years

Selling Price 551250 638141 814447
Realtor Fees (@5%) 27562.5 31907 40722
Other Selling fees 2000 2000 2000
Princ OS $384,936.59 $360,135.11 $312,132.28
Net Proceeds $136,750.91 $244,098.64 $459,592.67

Funds at Closing 117000 117000 117000

Opportunity Cost of Extra Payments Incl. Funds Used at Initial
Closing $15,266.04 $40,401.14 $89,049.69

Net FV $4,484.87 $86,697.49 $253,542.98

PV of Future Net (NPV) $4,163.70 $71,999.64 $174,863.49

In this scenario, if the condo price increases 5.0% annually, Rebecca's NPV would be positive
after 2, 5, and 10 years. In 2 years, the NPV would be $4,163.70. In 5 years, the NPV would be
$71,999.64, and in 10 years, it would be $174,863.49. The NPV factor would increase by 17.29
times from 2 to 5 years and 42 times from 2 to 10 years.

Conclusion

Based on the financial scenario analysis, we recommend that Rebecca should buy the
condo, which would best fit her plan to move another house after staying in the condo between 5
to 10 years. The scenarios that would maximize her NPV if the condo prices increase 2.0%
(Scenario C) or 5.0% annually (Scenario D). If condo prices increase 2.0% or 5.0% annually,
Rebecca's NPV is maximized if she purchased the condo and stayed there after ten years. We do
understand the risk involved is the condo price could decrease in percentage then increase. Still,
when we review that scenario, which the condo price decreases 10.0% then back to the purchase
price, then increases to 10.0%, Rebecca would have to stay in the condo for 10+ years to receive

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a positive NPV. Unfortunately, the NPV amount is miniscule in comparison to Scenario C or D.

We also recognize there are qualitative considerations that Rebecca would factor in as well such
as moving to another neighborhood in Toronto, moving to another city in Canada, and applying
for another job in her career. If she considers these qualitative factors, it could possibly influence
her to deviate in her decision. We do not recommend purchasing a condo then selling after two
years. In every scenario we analyze, Rebecca's NPV is in the negative except in Scenario D,
which results as positive; however, the amount is under $10,000.00.

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