Cash Flow Statement with Financing (Borrowing). Rework Example 10.3, assuming that $62,500 of the $125,000 paid for the investment is obtained through debt financing (debt ratio = 0.5). The loan is to be repaid in equal annual installments at 10% interest over five years. The remaining

Question

Cash Flow Statement with Financing (Borrowing)

Rework Example 10.3, assuming that $62,500 of the $125,000 paid for the investment is obtained through debt financing (debt ratio = 0.5). The loan is to be repaid in equal annual installments at 10% interest over five years. The remaining $62,500 will be provided by equity (e.g., from retained earnings).

Accepted Answer

Given: Same as in Example 10.3, but $62,500 is borrowed and then repaid in equal installments over five years at 10% interest.
Find: Net after-tax cash flows in each year.

We first need to compute the size of the annual loan repayment installments as

$62,500(A/P, 10%, 5) = $16,487

Next, we determine the repayment schedule of the loan by itemizing both the interest and principal represented in each annual repayment.

Ending Balance	Principal Payment	Interest Payment	Beginning Balance	Year
$52,263	$10,237	$6,250	$62,500	1
41,002	11,261	5,226	52,263	2
28,615	12,387	4,100	41,002	3
14,989	13,626	2,861	28,615	4
0	14,988	1,499	14,989	5

The resulting after-tax cash flow is detailed in Table 10.6. The present-value equivalent of the after-tax cash flow series is

PW(15%) = -$85,333 + $29,158(P/F, 15%, 1) + ...
+ $89,065(P/F, 15%, 5)
= $44,439

When this amount is compared with the amount found in the case when there was no borrowing ($31,420), we see that debt financing actually increases the present worth by $13,018. This surprising result is largely caused by the firm’s being able to borrow the funds at a cheaper rate (10%) than its MARR (opportunity cost rate) of 15%. We should be careful in interpreting the result, however: It is true, to some extent, that firms can usually borrow money at lower rates than their MARR, but if the firm can borrow money at a significantly lower rate, that also affects its MARR, because the borrowing rate is one of the elements determining the MARR. Therefore, a significant difference in present values between “with borrowings” and “without borrowings” is not expected in practice. We will also address this important issue in Chapter 15.

Question 10.4: Cash Flow Statement with Financing (Borrowing). Rework Examp...

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