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Holdings accept the telecommunications project

(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.

(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.

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.

Answer:

ANSWER 1

The interest component of EMI over the life of the loan has been computed at $509378.61.

(For Computation refer Above)

  • There has been no intention to set off the loan earlier;

  • There has been no change in rate of interest;

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

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%

 

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%.

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)

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            
  • Changes in Working Capital is realised at end

Part B(iv)

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)

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 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)

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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