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