A biofuel subsidiary of Petrofac, Inc. is planning to borrow $12 million to acquire a small technol­ogy-based company. The rate on a 5-year loan is highly variable; it could be as low as 7%, as high as 15%, but is expected to be 10% per year. The com­pany will only move forward with the acquisition offer if the AW is below $6.1 million. The M&O cost is fixed at $3.1 million per year. The antici­pated sales price of the company could be $2 million if the interest rate is 7% or as much as $2.5 million if the rate is 15%, but will most likely be about $2.3 million at the 10% per year rate. Is the decision to move forward with the acquisition sensitive to the loan interest rate and salvage value estimates?

Question

What will be an ideal response?

Answer 1

Required AW < $-6.1 million

7%: AW = -12,000,000(A/P,7%,5) – 3,100,000 + 2,000,000(A/F,7%,5)
= -12,000,000(0.24389) – 3,100,000 + 2,000,000(0.17389)
= $-5,678,907 (< $-6,100,000; acceptable)


10%: AW = -12,000,000(A/P,10%,5) – 3,100,000 + 2,300,000(A/F,10%,5)
= -12,000,000(0.26380) – 3,100,000 + 2,300,000(0.16380)
= $-5,888,836 (< $-6,100,000; acceptable)

15%: AW = -12,000,000(A/P,15%,5) – 3,100,000 + 2,500,000(A/F,15%,5)
= -12,000,000(0.29832) – 3,100,000 + 2,500,000(0.14832)
= $-6,309,040 (> $-6,100,000; not acceptable)


The decision is sensitive, since AW at 15% exceeds maximum of AW = $-6,100,000