In this course project, we return to the 5789 Project. Earlier, we established the project’s feasibility and evaluated two loans for the project, sizing the loan using an LTC Ratio, a DCR Ratio, and a Debt Yield. The two loans include:
- A Base Case loan with twenty-year amortization and a 4.65% interest rate; using the three criteria, this loan was constrained by the DCR Ratio and sized to $15,875,057.
- An Optional Terms loan with thirty-year amortization and a 4.75% interest rate; using the three criteria, this loan was constrained by the LTC Ratio and sized to $17,938,400.
The following table provides the specific details of the Base Case loan and Optional Terms loan for the 5789 Project.
|
5789 Project |
Optional Terms Loan |
Base Case Loan |
|
Amount Borrowed |
$17,938,400 |
$15,875,057 |
|
Interest Rate |
4.75% |
4.65% |
|
Amortization |
30 years |
20 years |
|
ECB |
4.89% |
4.76% |
|
DCR in Year 3 |
2.51 |
2.31 |
|
RMB at End of Year 5 |
$16,413,320 |
$13,164,980 |
|
Project Cost |
$35,876,800 |
$35,876,800 |
|
Net Sale Proceeds in Year 5 |
$41,490,258 |
$41,490,258 |
|
Overall Project IRR |
10.16% |
10.16% |
|
Equity Required |
$18,072,938 |
$20,120,806 |
|
Before-Tax Equity Reversion |
$25,076,939 |
$28,325,279 |
|
Before-Tax IRR |
14.63% |
13.67% |
|
After-Tax Equity Reversion |
$23,606,023 |
$26,308,363 |
|
After-Tax IRR |
11.34% |
10.49% |
In the end, the developer decided to use the Optional Terms loan, which produces higher equity IRR’s for the investor than the Base Case loan. However, the Optional Terms loan has a higher effective cost of borrowing (ECB) and a higher remaining balance, and thus produces lower before- and after-tax reversions than the Base Case loan.
Interestingly, due to the longer amortization term, the Optional Terms loan has a higher DCR than the Base Case loan, indicating lower risk of a default if the project does not perform as expected. In addition, the Optional Terms loan requires a lower equity investment, which could be positive or negative, depending on the investor’s capital constraints
Based on the information above, answer the following questions to complete this project:
- Characterize the risks that the investor is taking under the Optional Terms financing scenario relative to the Base Case scenario.
- Indicate whether you feel that the increased equity IRRs adequately compensate the investor for these risks.
- In addition, indicate what other metrics or information you would need to complete your evaluation of the Optional Terms loan vs. the Base Case loan.
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