Question

Thomas Macdiarmid is a successful entrepreneur. He recently sold off a successful venture and pocketed $6 million in cash. Thomas is now considering a new venture. He has an opportunity to purchase a rundown strip mall in a large city. The mall would cost about $3 million and the needed renovations would cost an additional $3 million. Since Thomas has the $6 million in cash, he could use his own money to finance the entire project but he's thinking that it might be a less risky strategy to diversify, invest only half the money in the mall project and put the rest in other investments. This would require borrowing the other $3 million. Thomas has already spoken with a prospective lender who said she would be prepared to lend the
$3 million at 9 percent per year on a three-year term (the principal would have to be paid back in three years). Interest would have to be paid annually. Thomas estimates that the renovations would take about three months and the mall would be in full operation one month later.
Thomas recognizes that this is a fairly risky venture and he has come up with two possible estimates for the mall, a good news outcome and a bad news outcome.
Under the good news outcome, the mall would generate $1,125,000 in operating income (income before interest) in each year once the renovations were complete.
Under the bad news outcome, the mall would generate $250,000 in operating income (income before interest). Assume that the project would have a tax rate of 15 percent, and that all tax effects are reflected in operating income except for the tax effect of the additional debt or equity.
a. How much profit would the strip mall earn under each financing alternative and each outcome? What would Macdarmid's return on shareholders' equity for the four scenarios be?
c. Explain to Macdiarmid the advantages and disadvantages of using debt and the advantages and disadvantages of using equity.
d. If you were a prospective lender, would you lend $3 million to Macdiarmid? Explain.
e. Would you advise Macdiarmid to use debt or equity to raise the additional $3 million? Explain.



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  • CreatedFebruary 26, 2015
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