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Homework answers / question archive / Shiraz Industries is considering borrowing $200 million to fund a new project

Shiraz Industries is considering borrowing $200 million to fund a new project

Finance

Shiraz Industries is considering borrowing $200 million to fund a new project. The market is uncertain about the project’s risk so Shiraz will have to pay a 6% interest rate on this loan. The actual risk of the loan is low so that the appropriate loan rate given the risk of the project is 5%. The entire principal will be repaid after four years. The corporate tax rate is 20%. Determine the effect of the loan on the value of the project.

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Borrowal for new project $200 Mn

Interest on loan to be paid 6%

Appropriate loan rate for the project 5%

Step 1: Calculation of Interest payable @ 6% on borrowal

Future value = $200Mn ( 1+r )n

Where r is interest rate & n is number of years.

FV= $200Mn(1+0.06)4

= $252.5 Mn

Total payment including interest would be $ 252.5 Mn.

Step 2: Calculation of payment @ 5% risk free rate on borrowal

FV= $200Mn(1+0.05)4

= $243.1 Mn

Hence the total payment including interest @ risk free rate would be $ 243.1 Mn

Step 3: Differece between payments at Risk free rate & actual borrowal rate.

Total payments @ 6%   $ 252.5 Mn

Total payments @ 5% $ 243.1 Mn

-------------------

Differencial interest $     9.4 Mn

Step 4: Impact on project:

It is ideal for an entity to borrow @ risk free return whereas Shiraz Industries borrowing @ 6%.

The differential interest on this is $ 9.4Mn ( pre tax ). This interest is tax deductible @ 20%.

Hence project cost would go up by $ 7.52 Mn. ( 9.4Mn - 20% )

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