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Finance Exam Questions: Loan Amortization, Telecom Investment, Capital Restructuring

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?

T. 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: 

The prevailing corporate marginal tax rate is 20%, the expected return on the market portfolio is 15%, and the risk-free rate is 5%. Assume the firm’s cost of debt does not vary with capital structure and financial distress is costless.

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?

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

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