Question

Noting that there has been an increasing interest in organic foodstuffs with increasing affluence, Mr Tommy Tan is considering starting an organic food retail business in Singapore. He targets to have 8 retail outlets island-wide by end 2021. To maintain its target capital structure, the firm estimates that it will need to borrow $10 million to finance this growth. As the firm is tight on cash, it prefers to repay the loan in full only at the end of 10 years and only wants to service the interest on an annual basis.
The firm has approached several banks in the Singapore and 2 banks have signalled interest to be its main financier. JuneBank proposes an annual interest rate of 6.9% and the underwriting spread is 2%. BHR Bank offers the loan at an annual interest rate of 6.5% and the underwriting spread is 2.9%.

(a) What is the effective cost of borrowing from JuneBank?

(b) What is the effective cost of borrowing from BHR Bank?

Answer 1

Formula for effective cost = 2(FN)/A(T+1)

where F is total finance charges

N is number of payments per year

A is total repayment amount

T is total number of years

a) For June Bank,

F = 6.9% of 10 million = 690000

N = 1 (as repayment period is 10 years so number of payment per year equals to 1)

A = 10 million

T = 10

Effective cost of borrowing for June Bank = 2(6,90,000*1)/10,000,000(10+1)

Effective cost of borrowing for June Bank = 2*0.0627

Effective cost of borrowing for June Bank = 0.1254

So,Effective cost of borrowing for June Bank is 12.54%.

b) For BHR Bank,

F = 6.5% of 10 million = 650000

N = 1 (as repayment period is 10 years so number of payment per year equals to 1)

A = 10 million

T = 10

Effective cost of borrowing for BHR Bank = 2(6,50,000*1)/10,000,000(10+1)

Effective cost of borrowing for BHR Bank = 2*0.059

Effective cost of borrowing for BHR Bank = 0.1181

So, Effective cost of borrowing for BHR Bank is 11.81%.