In late 1984, Sonat, the Birmingham, Alabama-based, energy and energy services c

Question

In late 1984, Sonat, the Birmingham, Alabama-based, energy and energy services company, ordered six drilling rigs that can be partly submerged from Daewoo Shipbuilding, a South Korean shipyard. Daewoo agreed to finance the $425 million purchase price with an 8.5 year loan, at an annual interest rate of 9% paid semiannually. The loan principle is payable in 17 equal semiannual installments ($25 million every 6 months). At the time the loan was arranged, the market interest rate on such a loan would have been about 16%. If Sonat's marginal tax rate (federal plus state corporate taxes) was 50% at the time, how much would this loan be worth to Sonat?

Explanation / Answer

The interest on loan is 9% p.a., so Sonat must semi annual interest of 4.5%. The intetest will be paid on the loan balance as well as on the semi annual principal repayment of $25 million for the next 8.5 years.

The required rate of return at the time the loan was arranged is 16%. The marginal tax rate is given as 50% then the after tax return will be 8% and the 4% semi annually.

Assuming Pt is the loan balance in period t and semi annual interest of 4.5% which becomes 2.25% after tax:

After-tax semiannual interest payments = 0.0225

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