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

Explanation / Answer

For Good State

Return for Debtholder's after year 1 = 500,000*1.1 = $ 550,000

Return to Equity Holder = 3,000,000 - 550,000 = 2,450,000

For Bad State

Return for Debtholder = $300,000

Return for Equity Holder = 0

Expected Return for Equity Holder = 0.5*2,450,000 + 0.5*0 = $1,225,000

Expected return rate = 1225000/500000 - 1= 145%

This is a good project

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