In analyzing highest and best use as vacant, an appraiser determines three potential uses are legally and physically possible. Use A has an IRR of 12%, Use B has an IRR of 15%, and Use C has an IRR of 10%. If the required return is 14%, which use is financially feasible?
Correct Answer
A) Use B only
Why this is correct: For a use to be financially feasible in a highest and best use analysis, its expected return (here measured by IRR) must meet or exceed the market's required return (the hurdle rate). Only Use B's 15% IRR exceeds the 14% required return. Why the other choices are wrong: "All three uses" is wrong because Use C (10%) and Use A (12%) both fall below the 14% threshold. "Uses A and B" is wrong because Use A's 12% IRR is below the required 14%. "Use A only" is wrong because its 12% IRR is also insufficient. Exam tip: In highest and best use analysis, 'financially feasible' is a pass/fail filter. A use must pass this test to proceed to the final 'maximally productive' comparison.
Why This Is the Correct Answer
Use B is the only financially feasible option because its 15% IRR exceeds the 14% required return. Financial feasibility in highest and best use analysis requires that the expected return (IRR) be greater than the cost of capital or required return. When the IRR exceeds the required return, it indicates that the project will generate positive net present value and meet investor expectations. Only Use B satisfies this fundamental investment criterion.
Why the Other Options Are Wrong
IRR Over the Hurdle
Think of IRR as a high jumper and the required return as the hurdle bar - the IRR must 'jump over' (exceed) the required return hurdle to be financially feasible. Only jumpers who clear the bar succeed.
How to use: When you see IRR and required return comparisons, visualize the hurdle jump - only IRRs that are higher than the required return 'clear the hurdle' and are financially feasible.
Exam Tip
Always compare each IRR individually to the required return - don't get distracted by comparing IRRs to each other until you've first determined which ones pass the financial feasibility threshold.
Common Mistakes to Avoid
- -Confusing financial feasibility with maximally productive use - feasibility only requires exceeding the required return
- -Comparing IRRs to each other instead of to the required return threshold
- -Including uses that don't meet the financial feasibility threshold in the final analysis
Concept Deep Dive
Analysis
This question tests the financial feasibility component of highest and best use analysis, which is one of the four criteria (legally permissible, physically possible, financially feasible, and maximally productive). Financial feasibility is determined by comparing the Internal Rate of Return (IRR) of each potential use to the required rate of return or hurdle rate. The IRR represents the discount rate that makes the net present value of all cash flows equal to zero, essentially showing the project's expected return. For a use to be financially feasible, its IRR must exceed the required return, indicating that the investment will generate returns above the minimum acceptable threshold.
Background Knowledge
Highest and best use analysis requires that a property use meet four criteria: legally permissible, physically possible, financially feasible, and maximally productive. Financial feasibility is tested by comparing investment returns to required returns, with IRR being a common metric that represents the effective annual return rate of an investment.
Real-World Application
An appraiser evaluating a vacant downtown lot might find it could legally be used for office, retail, or residential development, and all are physically possible, but only the office development with a 16% IRR exceeds the 14% required return, making it the only financially feasible option to consider for highest and best use.
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