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%.

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

2. (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

Answer 1

To calculate the effective rate with given information let’s consider the below table;

For June Bank

Year	Interest Payment @ 6.9%	Loan Repayment	Underwriting @2%	Total payment to bank
1	0.69	0	0.2	0.89
2	0.69	0	0	0.69
3	0.69	0	0	0.69
4	0.69	0	0	0.69
5	0.69	0	0	0.69
6	0.69	0	0	0.69
7	0.69	0	0	0.69
8	0.69	0	0	0.69
9	0.69	0	0	0.69
10	0.69	10	0	10.69
Total	6.9	10	0.2	17.1

This table shows that we borrowed $10 million and repaid $17.1 million in 10 years

The Effective interest rate can be calculated using the RATE formula in Excel as it gives the interest rate per period on amount of loan

In Rate formula by taking Nper as 10, PV as 10 and FV as -17.10 we get 5.511% (have taken FV value as negative because it is total money going out of company)

So effective rate for June Bank is 5.511%

For BHS bank

Year	Interest Payment @ 6.5%	Loan Repayment	Underwriting @2.9%	Total payment to bank
1	0.65	0	0.29	0.94
2	0.65	0	0	0.65
3	0.65	0	0	0.65
4	0.65	0	0	0.65
5	0.65	0	0	0.65
6	0.65	0	0	0.65
7	0.65	0	0	0.65
8	0.65	0	0	0.65
9	0.65	0	0	0.65
10	0.65	10	0	10.65
Total	6.5	10	0.29	16.79

This table shows that we borrowed $10 million and repaid $16.79 million in 10 years

Using the same Rate formula by taking Nper as 10, PV as 10 and FV as -16.79 we get 5.319% (have taken FV value as negative because it is total money going out of company)

So effective rate for BHS Bank is 5.319%

We should take loan from BHS bank as the effective rate is 5.319% which is lower than effective rate of June bank of 5.511%. The 2.9% of underwriting spread looks high at the beginning but over the years its effect gets reduced.