Mitch Poirier is considering an investment in a multiple-unit, residential building. The building has 30 units, which
Question:
Mitch Poirier is considering an investment in a multiple-unit, residential building. The building has 30 units, which are all currently rented to tenants. Further details on the apartment building are provided in Exhibit I. If Mitch decides to proceed with the investment, he will purchase the apartment through a newly formed holding company (Poirier Holdings).
The apartment building, and required initial working capital, will require an investment of $1 million ($900,000 for the building and $100,000 for working capital). Mitch is contemplating various alternatives by which the apartment could be financed. The following four options are available:
1. Borrow $950,000 from the Bank of Calgary, with the remaining $50,000 being financed through personal equity. The loan would be repaid on a monthly basis over a 20-year term with an effective annual interest rate of 6%. The bank would require that the debt to equity ratio not exceed 3.75:1.
2. Borrow $750,000 in the form of an interest-only note from a local, wealthy businessperson, with the rest coming from personal equity. The loan would require annual interest payments, but no principal payments until the end of the 15-year term. Interest is payable at a rate of 7% per annum. The loan covenant stipulates that the debt to equity ratio not exceed 2.75:1.
3. Borrow $600,000 from the Bank of Edmonton, on a 15-year loan with an effective interest rate of 5%. The bank would require a debt to equity ratio of 5:1. An additional $300,000 could be obtained from issuing preferred shares to Joe Poirier, Mitch’s brother. The preferred shares would be cumulative, with a 6% dividend yield. Mitch would finance the remaining $100,000 through common equity.
4. Allow Joe to become a shareholder, whereby both Mitch and Joe would invest $500,000 in common share, equity financing. In this scenario, there would be no long-term debt taken by the Poirier Holdings. Mitch has contacted you, CPA, in order to provide assistance regarding the possible financing alternatives. Mitch would like you to assess the impact of four alternatives on the return on common equity, debt to equity ratio, and ability to pay dividends at the end of each year. Mitch will not proceed with the investment if the debt to equity covenant is likely to be violated, or the return on equity is below 10%. In addition, he would like to be able to draw out dividends
of at least $20,000.
Required
Prepare a report that addresses the concerns of Mitch Poirier by assessing the four financing alternatives and recommending a source of financing. A pro forma statement of financial position under each alternative for the future periods should be included in your report.