Question

Sigma Company, a large manufacturer, is planning to sell an existing subsidiary and use the funds to buy land and build new factory. The proceeds of the sale are likely to be delayed, so the Directors have estimated that 10 million € will be needed in 3 months’ time for a period of 6 months. Given this, the directors have decided that a bank loan would be appropriate as a form of finance rather than equity sources.

After checking that interest rate yield curves in the financial press are normal than inverted, the treasurer is now looking to hedge the interest rate exposure. Traditionally Sigma Company has used forward rate agreements (FRAs) for hedging interest rate risk exposure but the treasurer is now considering using interest rate futures, although he is concerned that futures will not be as good a hedge as the FRAs.

Sigma Company’s bank have offered an FRA on the following terms:

3v9 FRA 7.2 – 7.8%.

Which TWO of the following are possible reasons why the Directors decided that a bank loan was preferable to equity in this case?

Select one or more:

a. The factory will act as security on the loan

b. They believe Modigliani and Miller’s theory of gearing with taxation

c. All equity sources have higher issue costs than the loan

d. The servicing cost of the debt will be lower

Answer 1

Two of the reasons why the directors decided that a bank loan was preferable to equity are-

(b) They believe Modigliani and Miller theory of gearing with taxation-it believe that the value of a levered company is higher than the value of an unlevered company by an amount equal to the product of absolute amount of debt and tax rate. So they believed in Modigliani and Miller theory of gearing with taxation.

(C) all equity sources have higher issue costs than the loan-this is because equity financing is a greater risk to the investor than loan financing so the cost of equity is often higher than the cost of debt and has there is a issue cost involved with cost of equity and it is an additional expense to the company.

Rest of the two options are not the reasons because factory will act as a security is just like a collateral and servicing cost of debt is higher.

Correct answer is option (b) and option(c)