Suppose that an entrepreneur applies for a $500,000 loan to your bank to take a

Question

Suppose that an entrepreneur applies for a $500,000 loan to your bank to take a one-year project costing $1 million as described below. The required rate of return on the debt capital is 10% per year, while cost of equity capital is 20% per year. The WACC for the project is 15%. There are no taxes. The entrepreneur will provide $500,000 of equity capital up front to take the project. The maximum interest rate you can charge is 20%. Assume that all other covenants are satisfied. Is this a good project from the entrepreneur’s perspective? Is this a good project from the bank’s perspective? Show all work. Good State (50%)? Bad state (50%) Firm value? $3 million? $300,000 At maturity Suppose that an entrepreneur applies for a $500,000 loan to your bank to take a one-year project costing $1 million as described below. The required rate of return on the debt capital is 10% per year, while cost of equity capital is 20% per year. The WACC for the project is 15%. There are no taxes. The entrepreneur will provide $500,000 of equity capital up front to take the project. The maximum interest rate you can charge is 20%. Assume that all other covenants are satisfied. Is this a good project from the entrepreneur’s perspective? Is this a good project from the bank’s perspective? Show all work. Good State (50%)? Bad state (50%) Firm value? $3 million? $300,000 At maturity Suppose that an entrepreneur applies for a $500,000 loan to your bank to take a one-year project costing $1 million as described below. The required rate of return on the debt capital is 10% per year, while cost of equity capital is 20% per year. The WACC for the project is 15%. There are no taxes. The entrepreneur will provide $500,000 of equity capital up front to take the project. The maximum interest rate you can charge is 20%. Assume that all other covenants are satisfied. Is this a good project from the entrepreneur’s perspective? Is this a good project from the bank’s perspective? Show all work. Good State (50%)? Bad state (50%) Firm value? $3 million? $300,000 At maturity

Explanation / Answer

Cost of project = $1 million

Debt = $0.5 million @ 10%

Equity = $0.5 million @ 20%

WACC = 15%

Firm’s value after 1 year = 0.5*3 + 0.5*0.3 = 0.5*3.3 = 1.65

1 = 1.65 / (1 + r)

r = 1.65 / 1 - 1 = 0.65 = 65%

Return on asset or WACC = 65%

Even though bank charges 20%, the return on equity must be higher than 65%

Therefore, this is a good project with entrepreneur’s and financer’s perspective.

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