Question

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?

(c) Using the estimations in (a) and (b), determine the bank that the firm should borrow from. (1 mark)

Answer 1

(a) Loan Amount =$10,000,000

   Underwriting spread = 2% = 10,000,000 x 0.02 = 200,000

   Hence Present value of loan received (PV) =10,000,000-200,000 = 9,800,000

   Interest payment per year = 10,000,000 x 6.9% = 690,000

   Future value of loan to be repaid at the end of 10 years (FV) =10,000,000

Using the rate function in excel = RATE(NPER,-PMT,PV,-FV) we get,

   Effective cost of borrowing from June Bank = 7.187% =RATE(10,-690000,9800000,-10000000)

(b) Loan Amount =$10,000,000

   Underwriting spread = 2.9% = 10,000,000 x 0.029 = 290,000

   Hence Present value of loan received (PV) =10,000,000-290,000 = 9,710,000

   Interest payment per year = 10,000,000 x 6.5% = 650,000

   Future value of loan to be repaid at the end of 10 years (FV) =10,000,000

Using the rate function in excel = RATE(NPER,-PMT,PV,-FV) we get,

   Effective cost of borrowing from BHR Bank = 6.911% =RATE(10,-650000,9710000,-10000000)

(c) The firm should borrow from BHR Bank since the effective cost of borrowing is lessser.