As per my promise on my last blog posting, now I would discuss to determine MARR in the arrangement that the fund is mixed between equity and debt (borrowed fund). I would put two scenarios on the borrowed fund: 1st is ten million rupiah (21.74% of investment) and 2nd is forty million rupiah (86.96% of investment) which both are using the same pessimistic approach as mentioned on my 5 blog posting. By simulating these two scenarios expected that we could understand that changing the percentage of borrowing fund not only impacts the MARR, but also IRR of investment.
In the next blog posting, I plan to discuss ERR triggered by when I calculated the same borrowed fund scenario using most likely approach, the IRR result is very high and I suspect it might be problem of IRR calculation method as mentioned on Engineering Book page 205.
The feasible alternatives for the fund are fully equity, part of investment: ten million is using borrowed fund and part of investment: forty million is using borrowed fund.
The reference rate of borrowed fund, I use Panin Bank.
Based on equation on Engineering Book page 529
WACC = λ (1 – t) ib + (1- λ) ea
where λ is fraction of the total capital obtained from debt
t is income tax rate = 30%
ib is the cost of debt financing
ea is the cost of equity = MARR = 17.9% refer to my week 7th blog posting
For the cost of debt financing, informed by the bank is only 1.2% flat per month. But if we use that as cost of debt financing, it will be misleading in fact the bank only use that rate to show the total accumulative installment we pay to the bank not considering that we pay the installment per month. So the effective cost of debt is 2.13% per month or 25.59% per year with calculation as follows:
=irr(24,536667,-10000000,0) or =irr(24,
So for Scenario 1:
WACC1 = 21.74% * (1 – 30%) * 25.59% + (1 – 21.74%) * 17.90% = 17.90%
And IRR = 17.13%
For Scenario 2:
WACC2 = 86.96% * (1 – 30%) * 25.59% + (1 – 86.96%) * 17.90% = 17.91%
And IRR = Investment is not justified the cash flow per month is minus
Setting Minimum/ Selection Criteria
If the personal investor has equity to cover the whole investment required so he still choice to precede the investment with full equity or with borrowed fund with advantage to reduce our hurdle rate and the IRR of investment that consider the payment of installment is still higher than that hurdle rate.
If the personal investor has no full equity and really require borrowed fund then only consider that the IRR of investment that inclusive the payment of installment is still higher than WACC or not
Analysis/ Comparison of the Alternatives against the Criteria
If the rate of debt is lower than cost of equity than this borrowed fund can reduce our hurdle rate (WACC is lower than cost of equity)
But in this case the debt rate is higher than our cost of equity so then in this case the use borrowed fund increases our hurdle rate.
The second criterion is whether the monthly revenue can cover the payment of monthly debt installment or not.
In second scenario shown that the revenue generated by investment is not to pay the monthly debt installment, that’s why the monthly cash flow is negative.
Selection of the Best/ Preferred Alternative Compared against the Criteria
For this case, personal investor recommended to use fully equity with MARR 17.9%
IRR using full Equity discussed in my week 5th blog posting is 18.26%
Performance Monitoring and Post Evaluation of Result/ Follow up Assessment
Borrowed fund can reduce our hurdle rate in condition that the rate of borrowed fund must be lower than cost of equity.
The payment of debt installment increases the cost of investment that can reduce our rate of return.
The calculation of IRR has limitation, for scenario 2 because the cash flow is negative, it makes the IRR formula is error. In my next posting, I will discuss about ERR.
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