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Question 1

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?

2.Holdings, an Asia-Pacific telecommunications company, has excess capital and is looking to make a regional telecommunications investment. S. Corp won the contract to advise T. Holdings on the potential of the investment, and allows T. Holdings to pay for its charges in annual installments, starting at $2 million for the next year, and increasing at 10% annually until the final installment in the fifth year.

The project under consideration entails an initial infrastructural investment of $600 million, and subsequent investments of the same amount every five years. These assets will be depreciated on a straight-line basis to a book value of zero five years from the purchase, but can be salvaged for approximately half the original investment amount. Revenue for the next year is projected to be $800 million, and is expected to grow at an annual rate of 20% for four years (i.e., years 2 through 5), after which revenues are expected to remain at that level indefinitely. Annual variable costs and year-end net working capital associated with the project are estimated to be 30% and 10% of annual revenue respectively, and fixed costs are estimated to be $80 million per year

Neither the debt nor equity of T. Holdings is traded, but S. Corp reckons they are worth $3 billion and $6 billion respectively. In the immediate future, T. Holdings intends to recapitalize by issuing equity to repay all of their outstanding debt. In addition, S. Corp looked into Good Inc. and Bad Inc.—the former is a conglomerate with businesses such as global telecommunications, food and beverage, and financial services, whereas the latter is a pure-play which focuses on developing their telecommunications business in the AsiaPacific. Also, S. Corp provides the following information on these entities:

(a) (i) Calculate and justify a suitable weighted average cost of capital based on T. Holdings’ existing capital structure.

(ii) Justify and calculate a suitable discount rate for the telecommunications project.

(b) (i) Compute operating cash flows for the first five years.

(ii) Compute changes in net working capital for the first five years.

(iii) Compute NPV based on cash flow from assets for the first five years.  (iv) Should T. Holdings accept the telecommunications project?

3.

Debt-free, Inc., an unlevered firm, is planning to use debt in its capital structure. The firm currently has 5,000 shares outstanding trading at $60 per share. The firm plans to sell 150 6% annual-coupon, 10-year bonds at their face values of $1,000 each and use the proceeds to repurchase some of its shares. When the bonds mature, Debt-free, Inc. plans to reissue new bonds to pay off the principal and to “roll over” its debt this way indefinitely. Assume the firm’s cost of debt does not change and there are no costs of financial distress. Earnings before interest and tax are expected to remain at $28,000 per year forever and the firm has a dividend policy of paying out all of its earnings. Maureen currently owns 100 shares of Debtfree, Inc

(a) (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?

(v) Is capital structure irrelevant? Explain. (b) Redo part (a) assuming a one-tier corporate tax rate of 20% applies. Ignore personal income taxes.

Particulars

Value

Rate

0.30%

Time

360

Amount

        800,000

Monthly payment

$3,637.16

Particulars

Value

Rate

0.30%

Time

288

Amount

        800,000

Monthly payment

$3,637.16

Loan outstanding after 24 years

$235,208.19

Interest paid in 1st month of 25th year

$705.62

Particulars

Value

Monthly payment

 $       3,637.16

Time

                  360

Amount

 $   800,000.00

Total interest paid

 $   509,378.61

From the evaluation, it can be detected that the total interest paid during the period of 30 years is approximately 60% of the total loan amount. In addition, the major limitation is the term of the loan, while the refinancing is also conducted a draw back.

Particulars

Value

Rate

0.10%

Time

360

Monthly payment

$3,637.16

Present Value

$1,099,143.92

The major difference between the above solution is the difference in interest rate, which directly indicate that borrowing is much more benefits than to lend.

Particulars

Good Inc

Bad Inc

Beta

                      1.80

                    1.20

Market value of equity

 $ 10,000,000,000

 $ 4,000,000,000

Market value of debt

 $ 20,000,000,000

 $ 2,000,000,000

Total

 $ 30,000,000,000

 $ 6,000,000,000

Face value of debt

 $ 22,000,000,000

 $ 2,200,000,000

Years to debt maturity

                         15

                         5

Annual coupon rate

10%

8%

Risk free rate

5%

5%

Return on Market

15%

15%

cost of equity

23.00%

17.00%

WACC

13.00%

13.47%

The calculation is relevantly conducted in the above table, which depicts values of WACC for T. Holdings. The debt and equity combination of Bad Inc is supporting the current capital structure of T. Holdings. Hence, the WACC of 13.47% can be used for T. Holdings.

Particulars

Bad Inc

Beta

                    1.20

Market value of equity

 $ 4,000,000,000

Market value of debt

 $ 2,000,000,000

Total

 $ 6,000,000,000

Face value of debt

 $ 2,200,000,000

Years to debt maturity

                         5

Annual coupon rate

8%

Risk free rate

5%

Return on Market

15%

cost of equity

17.00%

WACC

13.47%

The discount rate of 13.47% can be used for the computation of the NV analysis for the projects proposed to T. Holdings.

Particulars

1

2

3

4

5

Revenue

 $         800,000,000

 $ 960,000,000

 $ 1,152,000,000

 $ 1,382,400,000

 $ 1,658,880,000

Variable cost

 $         240,000,000

 $ 288,000,000

 $    345,600,000

 $    414,720,000

 $    497,664,000

Fixed cost

 $           80,000,000

 $   80,000,000

 $      80,000,000

 $      80,000,000

 $      80,000,000

Payments

 $             2,000,000

 $     2,200,000

 $        2,420,000

 $        2,662,000

 $        2,928,200

Salvage

 $    300,000,000

Depreciation

 $         120,000,000

 $ 120,000,000

 $    120,000,000

 $    120,000,000

 $    120,000,000

EBIT

 $         358,000,000

 $ 469,800,000

 $    603,980,000

 $    765,018,000

 $    658,287,800

Tax

 $           71,600,000

 $   93,960,000

 $    120,796,000

 $    153,003,600

 $    131,657,560

PAT

 $         286,400,000

 $ 375,840,000

 $    483,184,000

 $    612,014,400

 $    526,630,240

Cash flow

 $         406,400,000

 $ 495,840,000

 $    603,184,000

 $    732,014,400

 $    646,630,240

Particulars

1

2

3

4

5

Net working capital

 $           80,000,000

 $   96,000,000

 $    115,200,000

 $    138,240,000

 $    165,888,000

Net Change in working capital

 $   16,000,000

 $      19,200,000

 $      23,040,000

 $      27,648,000

Particulars

0

1

2

3

4

5

Cash Flow

 $        (680,000,000)

 $ 406,400,000

 $    479,840,000

 $    583,984,000

 $    708,974,400

 $ 618,982,240

NPV

 $ 1,207,448,769.49

The calculation conducted in the above table directly indicates positive NPV values, which can allow T. Holding to improve its financial condition in future.

Particulars

Value

Earnings

 $      28,000

Number of shares

           5,000

Dividend per share

 $          5.60

Maureen shares @100

 $           560

Particulars

Value

150 Bonds @1000

 $    150,000

Market value per share

 $             60

Number of shares repurchased

           2,500

Particulars

Value

Earnings Before Interest

 $      28,000

Interest@6%

 $        9,000

Earnings

 $      19,000

Number of shares

           2,500

Dividend per share

 $          7.60

Maureen shares @100

 $           380

Particulars

Value

Unlevered firm

 $           560

Levered firm

 $           380

Investing in Bonds

 $           360

The new condition of Debt-free Inc will be problematic for the shareholders, as the debt-to-equity ratio is 1:1, which will reduce the shareholders’ value and raise debt payments.

Particulars

Value

Earnings

 $   28,000

Tax

 $     5,600

EAT

 $   22,400

Number of shares

        5,000

Dividend per share

 $       4.48

Maureen shares @100

 $        448

Particulars

Value

150 Bonds @1000

 $ 150,000

Market value per share

 $          60

Number of shares repurchased

        2,500

Particulars

Value

Earnings Before Interest

 $   28,000

Interest@6%

 $     9,000

Earnings

 $   19,000

Tax

 $     3,800

EAT

 $   15,200

Number of shares

        2,500

Dividend per share

 $       6.08

Maureen shares @100

 $        304

Particulars

Value

Unlevered firm

 $        448

Levered firm

 $        304

Investing in Bonds

 $        360

The debt combination of the firm is problematic, as it will reduce shareholders values and increase debt payments.

Bekaert, G. and Hodrick, R., 2017. International financial management. Cambridge University Press.

DeAngelo, H. and Stulz, R.M., 2015. Liquid-claim production, risk management, and bank capital structure: Why high leverage is optimal for banks. Journal of Financial Economics116(2), pp.219-236.

Robb, A.M. and Robinson, D.T., 2014. The capital structure decisions of new firms. The Review of Financial Studies27(1), pp.153-179.

Zeitun, R. and Tian, G., 2014. Capital structure and corporate performance: evidence from Jordan.

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