Question

Show Work, Please. Excel Preferably. Suppose you are considering investing in a new business that will cost $10 million. A bank is willing to lend you $7 million for the purchase with equity holders having to provide the remainder of the funds. the terms of the loan are: a 20-year loan with yearly payments at a fixed rate of 3%. You will sell the business after year 8. You estimate the business will have the following profits in years 1-8: $100,000 in year 1, $300,000 in year 2, and $400,000 year 3 through year 8. In year 8, and advisor tells you that given the expectation of increased competition that the business will likely only sell for $15 million at the end of year 8( ignore any tax issues).

a.) Calculate the return to equity holders if they provide the funds that the bank does not provide.

b.) Now that your equity investors have heard about the "evils of leverage" and refuse to borrow any money from the bank, calculate the return assuming equity holders put up the entire $10 million purchase price.

c.) Based upon your answers in a) and b), what are the benefits of leverage( borrowing money to finance purchase)? What other benefits of leverage are there to investors? Why might leveraging be bad?

Answer 1

Part (a)

Please see the table below. The last row highlighted in yellow is your answer. Figures in parenthesis, if any, mean negative values. All financials are in $. Adjacent cells in blue contain the formula in excel I have used to get the final output.

Part (b)

Please see te table below. It's the same as in part (a), i have changed the debt amount to 0, that's all.

Part (c)

Benefits of leverage:

• Initial down payment or own contribution or equity portion reduces drastically
• Higher equity IRR or return on investment
• Lower cost of funds (cost of debt is lower than that of equity)

Other benefits:

• Tax shield on interest payments

Leverage may be bad because:

• There is mandatory and obligatory debt servicing payment periodically. If business is passing through bad phase, debt servicing can lead to a distress situation.
• Debt increases the financial leverage and brings in lots of positive and negative covenants. Some of them are very restrictive in nature.
• Failure to meet debt obligations leads to events of default that have far reaching consequences.