Question

A small privately held corporation is trying to raise money for a business expansion. The total cost of the expansion is $5,000,000. The expected return on assets before taxes (EBIT) for the business expansion project based upon the expected probabilities of returns are .2 of an 8% return, .5 of a 10% return and .3 of a 12% return. The privately held corporation’s 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 based upon which loan is selected.

Loan option 1: The bank is willing to lend 60% of the costs of the project with a 10 year interest only loan at an annual contract rate of 6% with interest payable quarterly and a balloon note payment at the end of 10 years. The loan closing costs and set up fees will be 4% of the amount borrowed and the owners will be held personally responsible for the loan. The closing costs and fees must be paid in cash when the loan contract is signed and begins.

Loan option 2: The bank is also willing to lend 80% of the costs of the project with a 10 year interest only loan at an annual contract rate of 8.5% with interest payable quarterly and a balloon note payable at the end of 10 years. The loan closing cost is 5% of the amount borrowed and the owners will also be held personally responsible for the loan. The closing costs 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 _________

What is the expected return on equity investment for this business expansion project for each option of financing this expansion project based upon the expected return on total assets for the project?

Show all your calculations.

What is the expected EBIT for the expansion project? $ ______________

Total Interest Expense per year for Project Option 1 $_____________ Option 2 $___________

Earnings before Taxes per year for Project Option 1 $_____________ Option 2 $___________

Total Equity Investment for Option 1 $__________ Option 2 $__________

ROE before taxes if Option 1 is used? _________________%

ROE before taxes if Option 2 is used? ___________________%

Which option do you recommend and why?

Justify your answer with appropriate financial decision making analysis and data from your analysis based on the information available.

Answer 1

What is the APR for each loan?

Option 1: 6.55%

6% payable quarterly, hence interest rate per period = 6%/4 = 1.5%, n = number of periods = number of quarters in 10 years = 4 x 10 = 40, Let's assume loan amount is 100.

Quarterly payment = PMT (Rate, period, PV, FV) = PMT (1.5%, 40, -100, 100) = $ 1.50

Effective loan = Loan amount - closing cost = 100 - 4% x 100 = 96

Hence, effective interest rate per period = RATE (Period, PMT, PV, FV) = RATE (40, 1.50,-96,100) = 1.64%

Hence, APR = 4 x 1.64% = 6.55%

Option 2: 9.27%

6% payable quarterly, hence interest rate per period = 8.5%/4 = 2.125%, n = number of periods = number of quarters in 10 years = 4 x 10 = 40, Let's assume loan amount is 100.

Quarterly payment = PMT (Rate, period, PV, FV) = PMT (2.125%, 40, -100, 100) = $ 2.125

Effective loan = Loan amount - closing cost = 100 - 5% x 100 = 95

Hence, effective interest rate per period = RATE (Period, PMT, PV, FV) = RATE (40, 2.125,-95,100) = 2.32%

Hence, APR = 4 x 2.32% = 9.27%

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What is the expected EBIT for the expansion project?

Expected EBIT = (0.2 x 8% + 0.5 x 10% + 0.3 x 12%) x 5,000,000 =  510,000

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For the balance question I have put the two scenarios side by side showing all the calculations

Please see the table below. Please be guided by the second column titled “Linkage” to understand the mathematics. You can also understand the mathematics making use of [+] / [-] sign appearing in the first column. The rows highlighted in yellow contain the answer. All financials are in $.

Parameter	Linkage	Option 1	Option 2
Project cost	A	5,000,000	5000000
Loan %	B	60%	80%
Loan portion	C = A x B	3,000,000	4,000,000
Equity investment	D = A - C	2,000,000	1,000,000
Interest rate	E	6%	8.50%
EBIT	F	510,000	510,000
[-] Interest	G = E x C	180,000	340,000
Earnings before taxes	H = F - G	330,000	170,000
Equity Investment	D (above)	2,000,000	1,000,000
ROE	H / D	16.50%	17.00%