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FIN303 Financial Management

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Course Code: FIN303
University: Singapore University Of Social Sciences

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Country: Singapore

Question:

Question 1
You are considering taking out an $800,000 30-year loan with equal monthly payments with a bank, which quotes annual rates on its deposits and loans of 1.2% and 3.6%, respectively.
(a) Without constructing a loan amortization schedule,
(i) calculate the amount of interest that will be paid in the first month of the 25th year into the loan.
(ii) calculate the total amount of interest that will be paid over the life of the loan.
(b) Interpret your answer for (a)(ii) and discuss the limitation(s), if any, of such an interpretation.
(c) Calculate the present value of the loan payments using a discount rate of 1.2%.
(d) Interpret your answer for (c) as well as the difference between that answer and the actual loan principal. What can explain this difference?
The prevailing corporate marginal tax rate is 20%, the expected return on the market portfolio is 15%, and the risk-free rate is 5%. Assume the firm’s cost of debt does not vary with capital structure and financial distress is costless.
(a) (i) Calculate and justify a suitable weighted average cost of capital based on T. Holdings’ existing capital structure.
(ii) Justify and calculate a suitable discount rate for the telecommunications project.
(b) (i) Compute operating cash flows for the first five years.
(ii) Compute changes in net working capital for the first five years.
(iii) Compute NPV based on cash flow from assets for the first five years.
(iv) Should T. Holdings accept the telecommunications project?
Debt-free, Inc., an unlevered firm, is planning to use debt in its capital structure. The firm currently has 5,000 shares outstanding trading at $60 per share. The firm plans to sell 150 6% annual-coupon, 10-year bonds at their face values of $1,000 each and use the proceeds to repurchase some of its shares. When the bonds mature, Debt-free, Inc. plans to reissue new bonds to pay off the principal and to “roll over” its debt this way indefinitely. Assume the firm’s cost of debt does not change and there are no costs of financial distress. Earnings before interest and tax are expected to remain at $28,000 per year forever and the firm has a
dividend policy of paying out all of its earnings. Maureen currently owns 100 shares of Debtfree, Inc.
(a) (i) Calculate the total dollar annual dividend Maureen receives under the firm’s existing capital structure.
(ii) If the market learns of the capital restructuring before the exercise is completed, how many shares are repurchased under the planned capital restructuring?
(iii) Calculate total dollar annual dividend Maureen receives under the firm’s planned capital structure.
(iv) Debt-free, Inc. completes its planned capital restructuring but Maureen prefers the annual dividend payout of the unlevered firm. What is Maureen’s cash flow from homemade leverage by referencing the levered firm’s capital structure and assuming that she can borrow and lend at the same rate as the firm?

Answer:

ANSWER 1
Part A (i)
The amount of interest that shall be paid in the first month of the twenty fifth year is $ 705.6246.
The computation has been done by using IPIM formula in excel.

Sl No

Particulars

Amount ($)

1

Loan amount

800000

2

Tenure

30 years

3

Saving Interest Rate

1.20%

4

Loan Interest rate

3.60%

5

Monthly EMI

3637.16

6

Total Amount of Emi

1309378.61

7

Interest

509378.61

8

Computation of interest at the beginning of 25th Year

705.62

Part A (ii)
The interest component of EMI over the life of the loan has been computed at $509378.61.
(For Computation refer Above)
Part B
On perusal of the details presented in excel along with amortisation schedule for cross verification, it can be seen that under the proposed loan arrangement, the principal component is $ 800,000 and interest computed on the principal over 360 months i.e. tenure of the project is $5,09,378. The interest component represent approximately 60% of principal and has been generated over the years.  It shall also be pertinent to note that for repayment of loan, the amount initially is set against the principal and then against the interest, as result the same piled upto 60% over a period of 30 years. In addition, the interest amount is higher under the initial stage of loan and the same decreases as the loan maturity approaches.
The following assumptions have been undertaken while computation:

There has been no prepayment of loan;
There has been no intention to set off the loan earlier;
There has been no change in rate of interest;
There is no default of loan

Part C
The answer to the question of Present value of loan by discounting @1.2 % compounded monthly is $ 1,09,9143.923. (Refer Appendix-1)
Part D
On perusal of the computation in Excel, it shall be seen that the present value of loan when discounted @1.2% is greater than the initial amount of principal lent under the agreement. Further, the method is based on time value of money and the difference arise on account of different in rate of interest used. In addition, the rate of discount used for the purpose of computation of present value is risk free interest rate as interest on savings is nearly equivalent to risk free interest. Also, the discounted EMI includes both interest and principal.
The difference between the principal actually granted initially and the computed value of present loan by discounting @1.2% $ 2,99,143.9229. The same implies that I am paying extra amount to lender on account of risk that has been borne by him by giving me loan. The amount that has been awarded to lender on account of extra risk borne by him stands at $ 2,99,143.9229
Thus, in short the rationale for difference in interest rate and difference in principal computed and the principal actually is isk undertaken by the person lending the money.
 Question 2
Part A (i)
The computation of WACC is presented here-in-below:

Weighted Average Cost of capital

Sl NO

Particular

Cost

1

Cost of Debt

8%

2

Cost of Debt post tax

6.4%

3

Risk Free rate

5%

4

Market return

15%

5

Risk Premium

10%

6

Beta

1.20

7

Cost of Equity

17.00%

8

Weight of Debt

3.00

9

Weight of Equity

6

10

Weight of Debt

3

11

WACC

13.47%

 

Computation of beta

Sl NO

Particular

Cost

1

Beta Levered

1.2

2

Beta Unlevered

0.857142857

3

Beta of Proposed project

1.2

It shall be pertinent to note that for deriving the cost of equity of the tested company only Bad Inc.  Beta has been taken as the company activities are similar to the tested company. Accordingly, the cost of equity stands at 13.47%.
Part A (ii)
The discount rate which has been used for the purpose of analysing the project is 13.47%. The rationale for using the said rate as it encompasses the desired rate of return by the financers of the project i.e. cost and equity. Further, the rate specifies the minimum rate below which the company should not accept the project. (CFI Education Inc., 2018)
In addition, it has been assumed that MM approach holds good, hence even if the capital structure changes the cost of capital shall remain constant at 13.47%. Besides, the above stated rate represent the desired rate of return by equity and debt shareholders and serve as hurdle rate for the said project.
Part B (i)
The details of the cash flow for first five years of the project has been provided here-in-under:

Sl No

Particular

year 0

year 1

year 2

year 3

year 4

year 5

Terminal Value

1

Revenue

 

800

960

1152

1382.4

1658.88

 

2

Annual Working Cost (Variable)

 

-240

-288

-345.6

-414.72

-497.664

 

3

Fixed Cost

 

-80

-80

-80

-80

-80

 

4

Depreciation

 

-120

-120

-120

-120

-120

 

5

EBIT (1-2-3-4)

 

360

472

606.4

767.68

961.216

 

6

Tax (5*20%)

 

-72

-94.4

-121.28

-153.536

-192.2432

 

7

EBI (5-6)

 

288

377.6

485.12

614.144

768.9728

 

8

Depreciation

 

120

120

120

120

120

 

9

OCF

 

408

497.6

605.12

734.144

888.9728

 

Part B(ii)
The details of change in working capital has been provided in the solution above

Sl No

Particular

year 0

year 1

year 2

year 3

year 4

year 5

Terminal Value

1

Net Working Capital Level

 

80

96

115.2

138.24

165.888

 

2

Change in Net Working Capital

 

80

16

19.2

23.04

27.648

 

3

Net Cash flow from sale of Asset

 

 

 

 

 

 

240

4

Realisation of Net working capital at end

 

 

 

 

 

 

165.888

Part B(iii)

Sl No

Particular

year 0

year 1

year 2

year 3

year 4

year 5

Terminal Value

1

Infrastructural Investment

-600

 

 

 

 

 

 

2

Depreciation

 

-120

-120

-120

-120

-120

 

3

Salvage Value

 

 

 

 

 

 

240

4

Revenue

 

800

960

1152

1382.4

1658.88

 

5

Annual Working Cost

 

-240

-288

-345.6

-414.72

-497.664

 

6

Working Capital

 

-80

-16

-19.2

-23.04

-27.64

165.88

7

Fixed Cost

 

-80

-80

-80

-80

-80

 

8

Net Cash Flow

 

280

456

587.2

744.64

933.576

405.88

9

Tax

 

-72

-94.4

-121.28

-153.536

-192.2432

 

10

Cash Flow after Tax

 

208

361.6

465.92

591.104

741.3328

405.88

11

Depreciation

 

120

120

120

120

120

 

12

Cash Flow after Tax & Depreciation

 

328

481.6

585.92

711.104

861.3328

405.88

13

Discounting factor

1

0.881316

0.776718

0.684534

0.603291

0.53169003

0.53169003

14

Present Value of Cash flows

-600

289.0717

374.0674

401.0822

429.0026

457.9620621

215.8023493

15

Net Present Value

1566.988

 

 

 

 

 

 

Assumption

Fees paid in Annual instalment is sunk cost
Changes in Working Capital is realised at end

Part B(iv)
On the basis of above computation, the project shall be accepted as the Net present value computed stands at $1567.651at a discounting rate of 13.47 %. Since Net Present Value is positive, project shall be accepted.
Question 3
PART A (i)

Sl No

Particulars

Quantity

Rate

Amount

 

1

Share

5000

60

300000

 

2

10 Year Bond

150

1000

150000

 

3

Buy Back Shares

2500

60

150000

 

4

Cost of Debt before Tax

 

 

6%

 

5

Earnings Before Interest and Tax

 

 

28000

 

6

Tax Rate

 

 

NiL

 

7

Profit after Taxt

 

 

28000

 

8

Dividend Per Share

 

 

5.6

 

9

Dividend received by Maureen

100

5.6

560

Answer (a(i))

PART A (ii)

Sl No

Particulars

Quantity

Rate

Amount

 

1

Share

5000

60

300000

 

2

10 Year Bond

150

1000

150000

 

3

Buy Back Shares

2500

60

150000

 

4

Cost of Debt before Tax

 

 

6%

 

5

Earnings Before Interest and Tax

 

 

28000

 

6

Tax Rate

 

 

NiL

 

7

Profit after Tax

 

 

28000

 

8

Dividend Per Share

 

 

5.6

 

9

Dividend received by Maureen

100

5.6

560

 

10

Buy Back Shares

2500

60

150000

Answer (a(ii))

PART A (iii)

Sl No

Particulars

Quantity

Rate

Amount

 

1

Share

5000

60

300000

 

2

10 Year Bond

150

1000

150000

 

3

Buy Back Shares

2500

60

150000

 

4

Cost of Debt before Tax

 

 

6%

 

5

Earnings Before Interest and Tax

 

 

28000

 

6

Tax Rate

 

 

NiL

 

7

Profit after Tax

 

 

28000

 

8

Dividend Per Share

 

 

5.6

 

9

Dividend received by Maureen

100

5.6

560

 

10

Buy Back Shares

2500

60

150000

 

11

Earnings Before Interest and Tax

 

 

28000

 

12

Interest

 

 

9000

 

13

Profit after Tax

 

 

19000

 

14

Dividend per share

 

 

7.6

 

15

Dividend received by Maureen

100

7.6

760

Answer (a(iii))

PART A (iv)

Sl No

Particulars

Amount

1

No of shares under existing Capital Structure

100

2

Proportion of debt in the capital structure of the company

50%

3

Total Capital of Maureen

6000

4

Total  value of shares to be sold

3000

5

Total debt to be let out

3000

6

Receipt of dividend

380

7

Interest

180

8

Total Receipt

560

PART A (v)
As per Modigliani Miller theory, it is irrelevant to analyse the capital structure as the same does not contribute to the value of the company rather the same is derived by the net operating cash flow of the company. However, under such thesis there is no transaction cost and taxes. The assumption behind the same proposition is that there are no taxes and transaction cost for raising finance. However, the above proposition does not hold true when the aforesaid assumptions are violated. In such a scenario, MM has proposed that the value of the company shall be increased by the present value of tax savings on account of interest on debt.
In addition the theory holds that WACC of the company remains consistent and addition of debt in the company capital structure increased cost of equity.
PART B (i,ii &iii)

Sl No

Particulars

Quantity

Rate

Amount

1

Share

5000

60

300000

2

10 Year Bond

150

1000

150000

3

Buy Back Shares

2500

60

150000

4

Cost of Debt before Tax

 

 

6%

5

Earnings Before Interest and Tax

 

 

28000

6

Tax Rate

 

 

20%

7

Profit after Tax

 

 

22400

8

Dividend Per Share

 

 

4.48

9

Dividend received by Maureen

100

4.48

448

10

Buy Back Shares

2500

60

150000

11

Earnings Before Interest and Tax

 

 

28000

12

Interest

 

 

9000

13

Profit after Tax

 

 

15200

14

Dividend per share

 

 

6.08

15

Dividend received by Maureen

100

6.08

608

PART B (iv)

Sl No

Particulars

Amount

1

No of shares under existing Capital Structure

100

2

Proportion of debt in the capital structure of the company

50%

3

Total Capital of Maureen

6000

4

Total  value of shares to be sold

3000

5

Total debt to be let out

3000

6

Receipt of dividend

304

7

Interest

180

8

Total Receipt

484

PART B (v)
As per Modigliani Miller theory, it is irrelevant to analyse the capital structure as the same does not contribute to the value of the company rather the same is derived by the net operating cash flow of the company. However, under such thesis there is no transaction cost and taxes. The assumption behind the same proposition is that there are no taxes and transaction cost for raising finance. However, the above proposition does not hold true when the aforesaid assumptions are violated. In such a scenario, MM has proposed that the value of the company shall be increased by the present value of tax savings on account of interest on debt.
In addition the theory holds that WACC of the company remains consistent and addition of debt in the company capital structure increased cost of equity.
References:
CFI Education Inc. (2018). WACC. Retrieved October 3, 2018, from corporatefinanceinstitute.com: https://corporatefinanceinstitute.com/resources/knowledge/finance/what-is-wacc-formula/
Study.com. (2018). The Modigliani-Miller Theorem: Definition, Formula & Examples. Retrieved October 3, 2018, from Study.com: https://study.com/academy/lesson/the-modigliani-miller-theorem-definition-formula-examples.html

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