Financial issues

In many situations, the IRS does not allow reinvestment of funds generated by a project without an interim tax penalty. This can be important when you compare one long-term investment to multiple short-term investments that are otherwise identical. For example, consider a farmer in the 40% tax bracket who purchases grain that costs $300, and that triples its value every year.
• If the IRS considers this farm to be one long-term two-year project, the farmer can use the first harvest to reseed, so $300 seed turns into $900 in one year and then into a $2,700 harvest in two years. Uncle Sam considers the profit to be $2,400 and so collects taxes of $960. The farmer is left with post-tax profits of $1,440.
• If the IRS considers this production to be two consecutive one-year projects, then the farmer ends up with $900 at the end of the first year. Uncle Sam collects 40% ·$600 = $240, leaving the farmer with $660. Replanted, the $660 grows to $1,980, of which the IRS collects another 40% ·$1, 980 = $792. The farmer is left with post-tax profits of 60% ·$1, 980 = $1, 188.
The discrepancy between $1,440 and $1,188 is due to the fact that the long-term project can avoid the interim taxation. Similar issues arise whenever an expense can be reclassified from “reinvested profits” (taxed, if not with some credit at reinvestment time) into “necessary maintenance.”
Although you should always get taxes right—and really know the details of the tax situation that applies to you—be aware that you must particularly pay attention to getting taxes right if you are planning to undertake real estate transactions. These have special tax exemptions and tax depreciation writeoffs that are essential to getting the project valuation right.

We have not covered risk yet, because we did not need to. In a risk-neutral world, all that matters is the expected rate of return, not how uncertain you are about what you will receive. Of course, we can assess risk even in a risk-neutral world, even if risk were to earn no extra compensation (a risk premium).
So, which investment is most risky: full ownership, loan ownership, or levered ownership? As the visual shows, the loan is least risky, followed by the full ownership, followed by the levered ownership. Your intuition should tell you that, by taking the mortgage, the medium-risky project “building” has been split into a more risky project “levered building” and a less risky project “mortgage.” The combined “full building ownership” project therefore has an average risk.
It should not come as a surprise to learn that all investment projects expect to earn a 10%rate of return. After all, 10% is the time-premium for investing money. Recall from the previous posts that the expected rate of return (the cost of capital) consists only of a time-premium and a risk premium. (The default premium is a component only of promised interest rates, not of expected interest rates). By assuming that investors are risk-neutral, we have assumed that the risk premium is zero. Investors are willing to take any investment that offers an expected rate of return of 10%, regardless of risk.
Although our example has been a little sterile, because we assumed away risk preferences, it is nevertheless very useful. Almost all projects in the real world are financed with loans extended by one party and levered ownership held by another party. Understanding debt and equity is as important to corporations as it is to building owners. After all, stocks in corporations are basically levered ownership claims that provide money only after the corporation has paid back its loans. The building example has given you the skills to compute state-contingent, promised, and expected payoffs, and state-contingent, promised, and expected rates of returns—the necessary tools to work with debt, equity, or any other state-contingent claim. And really, all that will happen later when we introduce risk aversion is that we will add a couple of extra basis points of required compensation—more to equity (the riskiest claim) than to the project (the medium-risk claim) than to debt (the safest claim).