Question

A corporation is trying to raise money for a business expansion. The total cost of the expansion is $1,000,000. The expected return on assets before taxes of the business expansion project is 10% on the total asset investment. (Expected probabilities of returns are .25 of an 8% return, .5 of a 10% return and .25 of a 12% return.)

After the privately held corporation owners are considering two options which involve obtaining one of two types of loans from an area bank. The current individual stock investors will put in the needed additional equity investment capital for the expansion project.

Loan option 1: The bank is willing to lend 60% of the $1,000,000 project with a 7 year interest only loan at an annual contract rate of 8% with interest payable quarterly and a balloon note payment at the end of 7 years. The loan closing costs will be 4% of the amount borrowed and the owners will be held personally responsible for the loan. The closing costs fees must be paid in cash when the loan contract is signed and begins.

Loan option 2: The bank is also willing to lend 70% of the $1,000,000 project with a 7-year interest only loan at an annual contract rate of 9% with interest payable quarterly and a balloon note payable at the end of 7 years. The loan closing cost is 5% of the amount borrowed and the owners will also be held personally responsible for the loan. The set up fees must be paid in cash when the loan contract is signed and begins.

To assist in this financial decision making situation, calculate the follow:

What is the APR for each loan?  

Option 1 _________                      

Option 2 ___________

If Option 2 is selected, what is the incremental cost of borrowing the additional amount of money?

Incremental Cost of Borrowing ________________%

What is the expected return on investment for this business expansion project for each option of financing this expansion project?

ROE if Option 1 is used? __________                                      

ROE if Option 2 is used? ___________________

Which option do you recommend and why?  

Answer 1

We can calculate the APR as below:

Option 1: The loan amount is will be $ 600,000 and interest rate is 8% payable quarterly for 7 years. The closing fees are 4% or (600000*4%) = $ 24000 . The annual interest payments will be (600000 * 8%) = $ 48000. Since the net loan amount is only (600000-24000) = $ 576000, the APR will be (48000/576000) = 8.33%

Option 2: The loan amount is will be $ 700,000 and interest rate is 9% payable quarterly for 7 years. The closing fees are 5% or (700000*4%) = $ 35000 . The annual interest payments will be (700000 * 9%) = $ 63000. Since the net loan amount is only (700000-35000) = $ 665000, the APR will be (63000/665000) = 9.47%

If option 2 is selected then effectively, the company is receiving additional funding of (665000-576000) = $ 89000 and its interest cost increases by $ 15000, hence it incremental cost of borrowing is 16.85%

ROE Calculation:

Expected Project Return = 10% (given to us) which should give us expeced cash flow of $100,000 per annum (10% of $ 1000000)

Option 1: Equity = $ 424000 and Debt will be $576000 and interest cost is 48000. After paying the interest, the residual left for the Equity holders is $ 52000 which means ROE of (52000/424000) = 12.26%

Option 2: Equity = $ 335000 and Debt will be $665000 and interest cost is 63000. After paying the interest, the residual left for the Equity holders is $ 37000 which means ROE of (37000/335000) = 11.04%

Given that the ROE in Option 1 is better than Option 2, it makes sense to go with Option 1.