Apartment HoldCo.

|COMM313-001| |Louise M. Lu 1016 3149 |Vicky Z. Chen 1016 2767||Evelyn Q. Tian 1016 3782|Maria A. Yu 0633 2939|

Agenda• Background• Introduction of four alternatives• Criteria • Assumptions• Analysis of four alternatives• Reccomendation

Background

An investment in a 30-unit, residential building

Requires $1 million investment including $900,000 for the building and $100,000 for working capital.

Four alternatives to finance the apartment

4 Alternatives$950,000 in Debt and $50,000 in Common Equity

$750,000 7% Interest Bond and $250,000 in Common Equity

$600,000 in Debt, $300,000 in Preferred Shares and $100,000 in Common Equity

$500,000 each in Common Equity

CriteriaReturn on common-equity(ROE) should be larger than 10%

Debt-to-equity ratio cannot exceed certain ratio depending on the requirement of alternatives

Ability to pay dividends at least $20,000

The working capital should be always above $100,000

Information about the operations of the buildingThe useful life of the building is 30 years, with a residual value of $100,000

According to be the nature of business, all the revenues and expenses can be assumed to be on a cash basisHistorically turnover is about one tenant per year. And the unit will be vacant for 3 months for the new tenant to move in

Last Year Two Years Ago Three Years Ago Four Years Ago

Advertising 1,500 1,250 2,250 1,760

Amortization 23,333 23,333 23,333 23,333

Bad debt expense 0 550 0 0

Insurance 4,450 4,450 4,250 4,250

Office 5,500 5,700 6,700 4,200

Professional fees 2,500 2,250 2,250 2,000

Property management fees 30,000 30,000 30,000 30,000

Repairs and maintanence 23,550 45,375 17,075 17,500

Wages and benefits 5,575 5,275 4,775 5,735

Total operating expenses 96,408 118,183 90,633 88,778

Expense of last 4 years

Normalized net incomeEstimated Annual Revenue

Assumptions for 4 Alternatives

Forecasted expenses and earnings before income interest and taxes

Forecast Notes

Revenue 196,350

Expense

Advertising 1,690 Average of past 4 years

Amortization 26,667 Based on $900,000 cost, $100,000 residual value and 30 year useful life

Bad debt expense 0 Assumed to be 0

Insurance 4,450 Assumed to be the most recent year

Office 5,525 Average of past 4 years

Professional fees 2,250 Average of past 4 years

Property management fees 30,000 Average of past 4 years

Repairs and maintenance 25,875 Average of past 4 years

Wages and benefits 5,340 Average of past 4 years

Total operating expenses 101,797 Average of past 4 years

Earnings before interest and taxes $94,553 Average of past 4 years

Analysis of 4 alternatives

$950,000 loan from

the bank of Calgary

$50,000 through personal

equity

1st alterna

tive

Details of Loan:

20-year term Monthly repayment Effective annual interest rate: 6% Requirement: debt to equity ratio not exceed 3.75:1

Loan amount : PV=$950,000Payments: N=12*20=240Effective interest rate:6% Effective monthly rate: r=0.49%Using annuity formula: PV= PMT/r*[1+(1+r) -N ] PMT= 6719.27

Payment Beginning balance

Payments Interest expense

Principal reduction

Ending balance

1 950,000 6,719 4,624 2,095 947,9052 947,905 6,719 4,614 2,105 945,8003 945,800 6,719 4,604 2,116 943,6844 943,684 6,719 4,593 2,126 941,55812(Year 1) 926,385 6,719 4,509 2,210 924,17524(Year 2) 899,142 6,719 4,377 2,343 896,800239 13,341 6,719 65 6,654 6,687240(Year 12) 6,687 6,719 33 6,687 0

Alternative 1- Loan amortization schedule

Income statement

Cash flow statement

Statement of retained earnings

Balance sheet

Alternative 1- Preparation of Financial Statements

opening 1 2 3 13 14 15

Revenue 196,350 196,350 196,350 196,350 196,350 196,350

operating expenses 101,797 101,797 101,797 101,797 101,797 101,797

interest expenses 54,806 53,256 51,614 28,666 25,548 22,243

income 39,747 41,297 42,939 65,887 69,005 72,310

taxes-30% (11,924) (12389) (12882) (19766) (20702) (21693)

after-tax income 27,823 28,908 30,057 46,121 48,304 50,617

add back:amortization 26,667 26,667 26,667 26,667 26,667 26,667

deduct:principal debt payments (25,825) (27,375) (29,017) (51,966) (55,084) (58,389)

dividend (23,000) (23,000) (23,000) (23,000) (23,000) (23,000)

cash flow 5,665 5,200 4,707 (2,178) (3,114) (4,105)

opening 1 2 3 13 14 15

beginning 0 0 4,823 10,731 145,912 169,033 194,337income 0 27,823 28,908 30,057 46,121 48,304 50,617dividend 0 23,000 23,000 23,000 23,000 23,000 23,000ending 0 4,823 10,731 17,788 169,033 194,337 221,954

Statement of retained earnings

Alternative 1- Income statement & Cash flow statement

Alternative 1- Balance sheetOpening 1 2 3 13 14 15

AssetsCurrent assets 100,000 105,665 110,865 115,572 128,067 124,954 120,849Long-term assets:Apartment, cost 900,000 900,000 900,000 900,000 900,000 900,000 900,000Apartment,acc.amount - 26,667 53,334 80,000 346,660 373,326 399,992

Apartment,NBV 900,000 873,333 846,666 820,000 553,340 526,674 500,008Total assets 1,000,000 978,998 957,531 935,572 681,407 651,628 620,857Liabilities and equityLiabilitiesLong-term debt 950,000 924,175 896,800 867,783 462,363 407,279 348,890EquityCommon shares 50,000 50,000 50,000 50,000 50,000 50,000 50,000Retained earnings 4,823 10,731 17,788 169,033 194,337 221,954Total equity 50,000 54,823 60,731 67,788 219,033 244,337 271,954Total liabilities & equity 1,000,000 978,998 957,531 935,571 681,396 651,616 620,844

*Formula:Debt-to-equity ratio=total debt/ total equity Return on equity= after-tax income/ total equity

Opening Criteria 1 2 3 13 14 15

*Debt-to-equity ratio 19 <3.75:1 16.86 14.77 12.80 2.11 1.67 1.28

*Return on equity >10% 50.8% 47.6% 44.3% 21.1% 19.8% 18.6%

Minimum dividend >20,000 23,000 23,000 23,000 23,000 23,000 23,000

Working capital (current assets) 100,000 >=100,000 105,665 110,865 115,572 128,067 124,954 120,849

Conclusion: Not optimal as only three of four criteria are satisfied

Alternative 1- Examination of Criteria

Details of Note:

15-year term Monthly payment Annual interest rate: 7% Requirement: debt to equity ratio not exceed 2.75:1

$750,000Interest-only

note

$250,000Common

Shares

2ND Alternati

ves

Loan amortization schedule of interest only note

opening 1 2 3 4 5 6

Revenue 196,350 196,350 196,350 196,350 196,350 196,350

operating expenses 101,797 101,797 101,797 101,797 101,797 101,797

interest expenses 52,500 52,500 52,500 52,500 52,500 52,500

Income 42,053 42,053 42,053 42,053 42,053 42,053

taxes-30% (12,616) (12,616) (12,616) (12,616) (12,616) (12,616)

after-tax income 29,437 29,437 29,437 29,437 29,437 29,437

add back:amortization 26,667 26,667 26,667 26,667 26,667 26,667

deduct:principal debt payments 0 0 0 0 0 0

Dividend (20,000) (20,000) (20,000) (20,000) (20,000) (20,000)

cash flow 36,104 36,104 36,104 36,104 36,104 36,104

opening 1 2 3 4 5 6

beginning 0 0 9,437 18,874 28,311 37,748 47,186income 0 29,437 29,437 29,437 29,437 29,437 29,437dividend 0 (20,000) (20,000) (20,000) (20,000) (20,000) (20,000)ending 0 9,437 18,874 28,311 37,748 47,186 56,623

Statement of retained earnings

Alternative 2- Income statement & Cash flow statement

Alternative 2- Balance sheetOpening 1 2 3 4 5 6

AssetsCurrent assets 100,000 136,104 172,208 208,312 128,067 124,954 120,849Long-term assets:Apartment, cost 900,000 900,000 900,000 900,000 900,000 900,000 900,000Apartment,acc.amount - 26,667 53,334 80,000 106,667 133,333 160,000

Apartment,NBV 900,000 873,333 846,666 820,000 793,333 766,667 740,000Total assets 1,000,000 1,009,437 1,018,875 1,028,312 1,037,749 1,047,188 1,056,625Liabilities and equityLiabilitiesLong-term debt 750,000 750,000 750,000 750,000 750,000 750,000 750,00EquityCommon shares 250,000 250,000 250,000 250,000 250,000 250,000 250,000Retained earnings 9,437 18,874 28,311 37,748 47,186 56,623Total equity 250,000 259,437 268,874 278,311 287,748 297,186 306,623Total liabilities & equity 1,000,000 1,009,437 1,018,874 1,028,311 1,037,748 1,047,186 1,056,623

*Formula:Debt-to-equity ratio=total debt/ total equity Return on equity= after-tax income/ total equity

Opening Criteria 1 2 3 4 5 6

*Debt-to-equity ratio 3.00 <2.75:1 2.89 2.79 2.69 2.61 2.52 2.45

*Return on equity >10% 11.8% 11.3% 10.9% 10.6% 10.2% 9.9%

Minimum dividend >20,000 20,000 20,000 20,000 20,000 20,000 20,000

Working capital (current assets) 100,000 >=100,000 136,104 172,208 208,312 244,416 280,521 316,625

Conclusion: Not optimal as only three of four criteria are satisfied

Alternative 2- Examination of Criteria

Details of Loan:

15-year term Monthly repayment Effective annual interest rate: 5% Requirement: debt to equity ratio not exceed 5:1

$600,000Loan from

the Bank of Edmonton

$300,000Preferred

Shares

$100,000Common

Shares

3rd Alternatives

Alternative 3- Meet the criteria

1. Debt-equity ratio is not violated 2. ROE exceeds 10%

3. Dividends of only $20,000 can be paid

annually

4.The working capital should not decrease below $100,000 ( in

order to pay for emergency repairs,

etc.)

Alternative 3- Loan amortization schedule for debt

payment Beginning bal.

payments Interest exp.

Principal red. Ending bal.

1 600,000 4,710 2,444 2,266 597,734

2 597,734 4,710 2,435 2,275 595,459

3 595,459 4,710 2,426 2,284 593,175

12 574,564 4,710 2,341 2,369 572,195

24 545,487 4,710 2,222 2,488 542,999

168 59,520 4,710 242 4,468 55,053

180 4,691 4,710 19 4,691 0

Given annual rate=5%, payments of 12*15=1801+EAR=(1+EMR)12---EMR/ monthly rate=0.42%,PV(600,000)=PMT/r[1-1/(1+r )12]---PMT monthly=4710

Alternative 3- Income statementyear opening 1 2 3 4 5 13 14 15

Revenue 196,350 196,350 196,350 196,350 196,350 196,350 196,350 196,350

Operating expense

101,797 101,797 101,797 101,797 101,797 101,797 101,797 101,797

Interest expense(from loan amortization)

28,716 27,326 25,866 24,333 22,724 6,587 4,090 1,469

income 65,837 67,227 68,687 70,220 71,829 87,966 90,463 93,085

Tax-30% 19,751 20,168 20,606 21,066 21,549 26,390 27,139 27,926

After-tax income 46,086 47,059 48,081 49,154 50,280 61,576 63,324 65,159

Alternative 3- Statement of cash flowyear openin

g1 2 3 4 5 13 14 15

After-tax income 46,086 47,059 48,081 49,154 50,280 61,576 63,324 65,159

+amortization 26,667 26,667 26,667 26,667 26,667 26,667 26,667 26,667

-principal payment 27,805 29,196 30,655 32,188 33,798 49,934 52,431 55,053

-dividend(prf) 18,000 18,000 18,000 18,000 18,000 18,000 18,000 18,000

-dividend(common)

20,000 20,000 20,000 20,000 20,000 20,000 20,000 20,000

Cash flow 6,948 6,530 6,093 5,633 5,149 309 -440 -1,227

Alternative 3- Working capital

Cash flow 6,948 6,530 6,093 5,633 5,149 309 -440 -1,227year opening 1 2 3 4 5 13 14 15

Current asset/working capital

100,000 106,948 113,478 119,571 125,204 130,353 145,857 145,417 144,190

>100,000

Alternative 3- Balance sheetyear opening 1 2 3 4 5 13 14 15Lia-long-term debt(from loan amort.)

600,000 572,195 542,999 512,344 480,155 446,358 107,484 55,053 0

E-prf share 300,000 300,000 300,000 300,000 300,000 300,000 300,000 300,000 300,000

E-common share 100,000 100,000 100,000 100,000 100,000 100,000 100,000 100,000 100,000

E-retained earnings=income-div.

- 8,086 17,145 27,226 38,380 50,660 196,850 222,174 249,333

DE ratio 1.50 1.40 1.33 1.25 1.17 1.08 0.25 0.13 0.00ROE=after-tax income-preferred dividends/averagecommon share

28.1% 26.9% 25.7% 24.5% 23.3% 15.9% 15.3% 14.6%DE ratio is not violated

Average common equity= common share + previous year retained earnings

ROE is above 10%

Alternative 3- Conclusion

Year 1 2 3 4 5 …… 13 14 15ROE 24.59% 24.44% 24.13% 23.69% 23.14% …… 17.33% 16.64% 15.98%

DE 1.40 1.33 1.25 1.17 1.08 …… 0.25 0.13 0.00

Max Div.

-20,000 -20,000 -20,000 -20,000 -20,000 -20,000 -20,000 -20,000 -20,000

working capital

100,000 106,948 113,478 119,571 125,204 130,353 145,857 145,417 144,190

$500,000From Mitch

$500,000From Joe

4th alternative

Alternative 4 – ROE Assessment Opening Year1 Year2 Year3 Year4 Year5

Income StatementRevenue 196,350 196,350 196,350 196,350 196,350 Operating expenses 101,797 101,797 101,797 101,797 101,797 Interest expense N/A Income 94,553 94,553 94,553 94,553 94,553 Taxes-30% 28,366 28,366 28,366 28,366 28,366 After-tax income 66,187 66,187 66,187 66,187 66,187

Cash FlowAfter-tax income 66,187 66,187 66,187 66,187 66,187 Add:Amortization 26,667 26,667 26,667 26,667 26,667 Less: Principal debt payment N/ALess:divedend (60,000) (60,000) (60,000) (60,000) (60,000)Cash flow 32,854 32,854 32,854 32,854 32,854

Statement of Retained EarningsBeginning 0 6,187 12,374 18,561 24,748 Income 66,187 66,187 66,187 66,187 66,187 Dividend (60,000) (60,000) (60,000) (60,000) (60,000)Ending 6,187 12,374 18,561 24,748 30,936

Alternative 4 – ROE Assessment ROE = Net Income / Shareholders’ Equity

After-tax Income 66,187 66,187 66,187 66,187 66,187

Total Shareholders' Equity 1,000,000 1,006,187 1,012,374 1,018,561 1,024,748 1,030,936

Opening Year1 Year2 Year3 Year4 Year5

ROE 0 6.6% 6.5% 6.5% 6.5% 6.4%

ROE < 10%

Alternative 4 – Dividend Assessment

Statement of Retained EarningsBeginning 0 6,187 12,374 18,561 Income 66,187 66,187 66,187 66,187 Dividend (60,000) (60,000) (60,000) (60,000)Ending 6,187 12,374 18,561 24,748

Opening Year1 Year2 Year3 Year4

74,245 80,432 86,619 66,187 66,187 66,187 (60,000) (60,000) (60,000)80,432 86,619 92,807

Year13 Year14 Year15

…

Annual Dividend > $20,000

Alternative 4 – Conclusion ROE RATIO (Average) 6.3% Per Year Unsatisfactory

DE RATIO N/A Satisfactory

DIVIDEND PAID $6,000 Per Year Satisfactory

Alternative 4 -Recommendation Alternative 1 Year 1 Year 2 Year 3 　 Year 14 Year 15

ROE 50.80% 47.60% 44.30% 19.80% 18.60%

DE 16.86 14.77 12.8 1.67 1.28

Dividend $20,000 $20,000 $20,000 $20,000 $20,000

Alternative 2 　ROE 11.80% 11.30% 10.90% 7.90% 7.70%

DE 2.89 2.79 2.69 - -

Dividend $20,000 $20,000 $20,000 $20,000 $20,000

Alternative 3 　ROE 28.10% 26.90% 25.70% 　 15.30% 14.60%

DE 1.4 1.33 1.25 　 0.13 -

Dividend $20,000 $20,000 $20,000 　 $20,000 $20,000

Alternative 4 　ROE 0.1 0.1 0.1 0.1 0.1

DE N/A - - - N/A

Dividend $60,000 $60,000 $60,000 　 $60,000 $60,000

…