You are considering taking out an $800,000 30-year loan with equal monthly payments with a bank, which quotes annual rates on its deposits and loans of 1.2% and 3.6%, respectively.
(a) Without constructing a loan amortization schedule,
(i) calculate the amount of interest that will be paid in the first month of the 25th year into the loan.
(ii) calculate the total amount of interest that will be paid over the life of the loan.
(b) Interpret your answer for (a)(ii) and discuss the limitation(s), if any, of such an interpretation.
(c) Calculate the present value of the loan payments using a discount rate of 1.2%.
(d) Interpret your answer for (c) as well as the difference between that answer and the actual loan principal. What can explain this difference?
(i) Calculate the total dollar annual dividend Maureen receives under the firm’s existing capital structure.
(ii) If the market learns of the capital restructuring before the exercise is completed, how many shares are repurchased under the planned capital restructuring?
(iii) Calculate total dollar annual dividend Maureen receives under the firm’s planned capital structure.
(iv) Debt-free, Inc. completes its planned capital restructuring but Maureen prefers the annual dividend payout of the unlevered firm. What is Maureen’s cash flow from homemade leverage by referencing the levered firm’s capital structure and assuming that she can borrow and lend at the same rate as the firm?
|
Loan Data |
|
|
Original Principal |
$ 800,000.00 |
|
Loan Term (Years) |
30 |
|
Annual Interest Rate |
3.60% |
|
Number of payments per Year |
12 |
|
Payments per Year |
$3,637.16 |
|
Formula |
Amount |
|
|
(i) Interest paid on the first month of 25th Year |
$598.33 |
|
Formula |
Amount |
|
|
(ii) Total Interest paid during the total life of the Loan |
(Payments per month*Loan term*No. of payment per year) |
$ 509,378.61 |
|
Formula |
Amount |
|
|
(iii) Present Value of Loan Payments |
Loan amount (1/(1+rate of interest)^no. of years |
$1,144,209.01 |
Answer in Part C shows that if an individual has $800,000 for the purpose of investment, then they can earn interest of ($1,144,209.01-$800,000), i.e. $344,209 in 30 years, however, if the same amount is borrowed then interest cost will be $ 509,378.61. This factor shows that interest earnings are lower than interest cost.
|
Computation of Weighted Average Cost of Capital |
|||
|
Particulars |
Cost |
Market Value (In Billions) |
Weighted average cost of Capital |
|
Cost of Equity as per CAPM (Rf + Beta(Rm-Rf) |
Cost |
Market Value (In Billions) |
Weighted average cost of Capital |
|
Cost of Debt |
23.00% |
6.00 |
15.33% |
|
Formula Kd* weight of debt +Ke *Weight of equity |
6.40% |
3.00 |
2.13% |
|
Total |
9.00 |
17.47% |
|
Kd: Cost of debt
Ke: Cost of equity (Ward and Forker, 2017)
This WACC is suitable for the discounting of the project as Good Inc. is a conglomerate with businesses their base is suitable for computation of WACC of T. Holdings as a whole.
|
Computation of Weighted Average Cost of Capital |
|||
|
Particulars |
Cost |
Market Value (In Billions) |
Weighted average cost of Capital |
|
Cost of Equity as per CAPM (Rf + Beta(Rm-Rf) |
17.00% |
6.00 |
11.33% |
|
Cost of Debt |
6.40% |
3.00 |
2.13% |
|
Formula Kd* weight of debt +Ke *Weight of equity |
|||
|
Total |
9.00 |
13.47% |
Kd: Cost of debt
Ke: Cost of equity
This WACC is suitable for the discounting of the project as Bad Inc. is a pureplay and proposed project is solely based on telecommunication project. Therefore, consideration of base of Bad Inc. is more viable.
|
Computation of Operating Cash Flows for first 5 Years (In Millions) |
|||||
|
Particulars |
Year 1 |
Year 2 |
Year 3 |
Year 4 |
Year 5 |
|
Sales Revenue |
$800.00 |
$ 960.00 |
$1,152.00 |
$1,382.40 |
$1,658.88 |
|
Variable Cost |
$240.00 |
$ 288.00 |
$345.60 |
$414.72 |
$497.66 |
|
Contribution |
$560.00 |
$ 672.00 |
$806.40 |
$967.68 |
$ 1,161.22 |
|
Fixed Cost |
$80.00 |
$ 80.00 |
$80.00 |
$80.00 |
$80.00 |
|
Depreciation |
$60.00 |
$ 60.00 |
$60.00 |
$60.00 |
$60.00 |
|
Advisory Fees to S Corp |
$2.00 |
$ 2.20 |
$ 2.42 |
$ 2.66 |
|
|
EBIT |
$420.00 |
$ 532.00 |
$666.40 |
$827.68 |
$ 1,021.22 |
|
Interest |
$240.00 |
$ 240.00 |
$240.00 |
$240.00 |
$240.00 |
|
EBT |
$180.00 |
$ 292.00 |
$426.40 |
$587.68 |
$781.22 |
|
Taxes @ 20% |
$36.00 |
$ 58.40 |
$85.28 |
$117.54 |
$156.24 |
|
EAT |
$144.00 |
$ 233.60 |
$341.12 |
$470.14 |
$624.97 |
|
Depreciation |
$60.00 |
$ 60.00 |
$60.00 |
$60.00 |
$60.00 |
|
Increase in Working Capital |
$80.00 |
$ 16.00 |
$19.20 |
$23.04 |
$27.65 |
|
Operating Cash Flows |
$124.00 |
$ 277.60 |
$381.92 |
$507.10 |
$657.32 |
|
Computation of Changes in Net Working Capital for the First 5 Years |
|||||
|
Particulars |
Year 1 |
Year 2 |
Year 3 |
Year 4 |
Year 5 |
|
Opening Working Capital |
$- |
$ 80.00 |
$96.00 |
$115.20 |
$138.24 |
|
Net Working Capital Associated |
$80.00 |
$ 96.00 |
$115.20 |
$138.24 |
$165.89 |
|
Increase in Working Capital |
$80.00 |
$ 16.00 |
$19.20 |
$23.04 |
$27.65 |
|
Computation of Net Present Value from assets for the First 5 Years |
||||||
|
Particulars |
Year 1 |
Year 2 |
Year 3 |
Year 4 |
Year 5 |
Total |
|
Operating Cash Flows |
$124.00 |
$ 277.60 |
$381.92 |
$507.10 |
$657.32 |
$1,947.95 |
|
Salvage Value at the end of 5th Year |
$- |
$- |
$- |
$- |
$300.00 |
$300.00 |
|
Total Operating Cash Flows |
$124.00 |
$ 277.60 |
$381.92 |
$507.10 |
$957.32 |
$2,247.95 |
|
Discounting Factor @ 13.47% |
0.881 |
0.777 |
0.684 |
0.603 |
0.532 |
|
|
Discounted Operating Cash Flows |
$109.28 |
$ 215.60 |
$261.41 |
$305.90 |
$508.93 |
$1,401.12 |
|
Total Initial Investment |
$600.00 |
$- |
$- |
$- |
$- |
$600.00 |
|
Net Present Value |
$801.12 |
|||||
By considering the positive net present value of the project, the company is recommended to select the project as it is profitable for the group. Net present value shows the financial feasibility of the project and the project over the year will provide net cash flow of $800 million (Petty, Titman, Keown, Martin, Martin & Burrow, 2015). Apart from this, the company will be able to enhance their operations in the Asia Pacific region to make a viable investment for the available excessive money. In addition to this, the proposed investment will improvise their product portfolio.
|
Computation of Annual Dividend received by Maureen under firm's Capital Structure |
|
|
Particulars |
Amount |
|
Earnings Before Interest and Taxes |
$28,000.00 |
|
Interest |
$- |
|
Earnings Before Taxes |
$28,000.00 |
|
Taxes |
$- |
|
Earnings After Taxes |
$28,000.00 |
|
Preference Dividend |
$- |
|
Earnings available for Equity Share Holders |
$28,000.00 |
|
Number of Outstanding Equity Shares |
$ 5,000.00 |
|
Earnings per Share |
$5.60 |
|
Dividend Payout Ratio |
100% |
|
Dividend per Share |
$5.60 |
|
Number of shares held by Maureen |
100 |
|
Dividend Received by Maureen |
$560.00 |
|
Computation of Number of Shares Repurchased under the Planned restructuring |
|
|
Particulars |
Amount |
|
Number of 6% Annual Coupon 10-year Bonds |
150 |
|
Face Value of Bonds |
$1000 |
|
The amount received by selling bonds |
$150000 |
|
Current Market Price of Equity shares |
$60 |
|
Number of Equity Shares Repurchased |
2500 |
|
Computation of Annual Dividend received by Maureen under firm's Planned Capital Structure |
|
|
Particulars |
Amount |
|
Earnings Before Interest and Taxes |
$ 28,000.00 |
|
Interest |
$ 9,000.00 |
|
Earnings Before Taxes |
$ 19,000.00 |
|
Taxes |
$ - |
|
Earnings After Taxes |
$ 19,000.00 |
|
Preference Dividend |
$ - |
|
Earnings available for Equity Share Holders |
$ 19,000.00 |
|
Number of Outstanding Equity Shares |
2500 |
|
Earnings per Share |
$ 7.60 |
|
Dividend Payout Ratio |
100% |
|
Dividend per Share |
$ 7.60 |
|
Number of shares held by Maureen |
100 |
|
Dividend Received by Maureen |
$ 760.00 |
CF (levered) = CF (unlevered) + t*interest
=$ 19,000.00+ (.0*9000)
=$19,000.00
Yes, the selected capital structure is more optimum it is because Maureen is able to stabilise their financial cost with the introduction of debt in the capital structure (Karadag, 2015). Further, the cost of equity is comparatively lower than the cost of debt. Therefore, she is able to earn a higher dividend on the retained shares.
|
Computation of Annual Dividend received by Maureen under firm's Capital Structure |
|
|
Particulars |
Amount |
|
Earnings Before Interest and Taxes |
$28,000.00 |
|
Interest |
$- |
|
Earnings Before Taxes |
$28,000.00 |
|
Taxes |
$5,600.00 |
|
Earnings After Taxes |
$22,400.00 |
|
Preference Dividend |
$- |
|
Earnings available for Equity Share Holders |
$22,400.00 |
|
Number of Outstanding Equity Shares |
$5,000.00 |
|
Earnings per Share |
$4.48 |
|
Dividend Payout Ratio |
100% |
|
Dividend per Share |
$4.48 |
|
Number of shares held by Maureen |
100 |
|
Dividend Received by Maureen |
$448.00 |
|
Computation of Number of Shares Repurchased under the Planned restructuring |
|
|
Particulars |
Amount |
|
Number of 6% Annual Coupon 10-year Bonds |
150 |
|
Face Value of Bonds |
$1000 |
|
The amount received by selling bonds |
$150000 |
|
Current Market Price of Equity shares |
$60 |
|
Number of Equity Shares Repurchased |
2500 |
|
Computation of Annual Dividend received by Maureen under firm's Planned Capital Structure |
|
|
Particulars |
Amount |
|
Earnings Before Interest and Taxes |
$ 28,000.00 |
|
Interest |
$ 9,000.00 |
|
Earnings Before Taxes |
$ 19,000.00 |
|
Taxes |
$ 3,800.00 |
|
Earnings After Taxes |
$ 15,200.00 |
|
Preference Dividend |
$ - |
|
Earnings available for Equity Share Holders |
$ 15,200.00 |
|
Number of Outstanding Equity Shares |
2500 |
|
Earnings per Share |
$ 6.08 |
|
Dividend Payout Ratio |
100% |
|
Dividend per Share |
$ 6.08 |
|
Number of shares held by Maureen |
100 |
|
Dividend Received by Maureen |
$ 608.00 |
CF (levered) = CF (unlevered) + t*interest
=$ 15,200.00+ (.2*9000)
=$17,000.00
Even with the consideration of tax the selected capital structure is optimum, it is because Maureen is able to stabilise their financial cost and take benefit of tax shield on interest as it is chargeable expense (Finkler, Smith, Calabrese and Purtell, 2016). Further, the cost of equity is comparatively lower than the cost of debt. Therefore, she is able to earn a higher dividend on the retained shares.
References
Finkler, S. A., Smith, D. L., Calabrese, T. D., & Purtell, R. M. (2016). Financial management for public, health, and not-for-profit organizations. CQ Press.
Karadag, H., (2015). Financial management challenges in small and medium-sized enterprises: A strategic management approach. EMAJ: Emerging Markets Journal, 5(1), pp.26-40.
Petty, J.W., Titman, S., Keown, A.J., Martin, P., Martin, J.D. & Burrow, M., (2015). Financial management: Principles and applications. Pearson Higher Education AU.
Ward, A.M. & Forker, J., 2017. Financial management effectiveness and board gender diversity in member-governed, community financial institutions. Journal of business ethics, 141(2), pp.351-366.
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