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Financial Implications of a Loan for the Lender and the BorrowerResearch Paper

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Ment of a Loan

The Lender

The Borrower

The Loan

Impact on Lender

Impact on Borrower

The ability of firms to borrow capital facilitates increased access to opportunities (Baye, 2007). Capital may be required for many purposes, such as expansion, investment in plant and equipment, or the purchase of real estate. In all cases firms should assess the potential for the investment, including all the costs associated with raising capital, to make a positive return for the firm (Bierman & Smidt, 2012). This report examines a potential (fictitious) loan made by a major lender to an S&P 500 borrower I order to assess the potential impact on the transaction on bath the lender and the borrower. The lender in this case is assumed to be the Bank of America, and the borrower is the American Water Works Company Incorporated.

The Lender

The lender is The Bank of America Corporation, which offers a wide range of banking, investment, and other financial services to consumers and businesses (Bank of America, 2016a). In 2015 the organisation achieved a total revenue of $83,416 million, of which $40,160 million was the next interest income on a fully taxable equivalent (FTE) basis (Bank of America, 2016b). After allowing for credit losses, and non-interest expenses, the organisation had a net income before taxes of $23,063 million (Bank of America, 2016b). Nearly half of the total revenues being interest, the bank relies heavily on the ability to make suitable loans.

The one of the bank is that of a financial intermediary, helping to create an alignment in the marketplace between those who want to invest money and those who want to borrow money (Howells & Bain, 2007). The banks aggregate money from account holders and investors, which are often invested for only a short period of time with a rapid turnover. The characteristics of deposits mean they are not suitable for direct lending in isolation, due to a mismatch in terms of typical deposit and required borrowing (Dowd, 2013). This capital only become suitable for longer term lending deposits are aggregated by the bank, effectively creating a larger lending fund (Armstrong, 2016). By aggregating deposits, which may also be supplemented with further borrowing, there are sufficient funds which may then be lent out on a longer term basis (Watson, 2014). Many banks will subsequently collaterisation of their debt portfolios, selling bonds where the bank takes a management fee, and the investors benefit from the interest payments made by the borrowers, as well as carry the risk of default within the collateralized bond itself (Pinto, 2014). Lateralisation often takes place, it can be problematic with particularly large land, they do not provide for a spread of risk within the sale of a bond (Howells & Bain, 2007). Therefore, it is assumed in this paper the lender will retain the debt, rather than collateralising it, and therefore any performance associated issues will impact directly on the lender.

3. The Borrower

The American Water Works Company Incorporated has its head office in Voorhees, New Jersey, and provide water to 45 states within the U.S. as well as Ontario in Canada (American Water, 2016). The organization provides water for approximately 15 million people (American Water, 2016). The company was a part of the German RWE Group between 2001 and 2008, but was diverted on 23 April 2008 through an initial public offering (IPO), on the New York Stock Exchange (American Water, 2008).

The current operations reflect the type of service provided, fragmented across the U.S., through the structure of numerous local subsidiaries in different areas, each of which manages both water systems, municipal drinking water, and dealing with waste water for businesses and residential customers (American Water, 2016). In 2015 the firm had total revenues of $82,507 million, with a net profit before interest and taxes of $22,154, the net profit after taxes was $15,888 million, which equated to an earnings per share (EPS) of $1.38 basic, and $1.28 diluted (American Water, 2016).

In line with many other water companies, American Water faces a number of challenges, these include decaying infrastructures with many pipes laid down decades ago, and a continuing failure to upgrade systems is increasing stress on the systems (EY, 2015). In addition, there are also increased demands for water with the contained construction of residential areas and start-up of new businesses (EY, 2015). Many firms in the industry have increase capacity not though direct investment, but through acquisitions strategies (EY, 2016). In this case it is assumed that American Water will take out a loan for investment purposes.

4. The Loan

American Water is assumed to be interested in making an investment, this will primarily be for the development of new water sources, including new pipelines from existing inland sources as well as the development of a desalination plant on the east coast. Therefore, the loan will create new assets as well as improve the current value of existing assets. The loan will be a substation amount, given that the firm currently has assets of $17,241, a loan of $15 million equates to 0.9% of total assets.

It is assumed the loan will be for a period of ten years on an interest only basis, with interest paid annually, and the full capital repayment due at the end of the term. The interest rate is set by the lender based on an assessment of the risk associated with the loan (Koch & MacDonald, 2009; Nellis & Parker, 2006). The structure of a loan interest rate starts with a basic rate set by the bank which will then be adjusted based on numerous factors, such as size of the business, amount of the loan, creditworthiness of the firm, as well as the mark up by the bank to ensure they make a profit on the loan (Koch & MacDonald, 2009). According to the World Bank, the mean interest rates for short to medium term borrowing in the U.S. for the private sector is 3.3% (World Bank, 2016). However, this is a starting point, and in the case of the loan for American Water, the term is also greater, which is often seen as presenting increased risk due to the money being tied up for longer. Therefore, other approaches to assessing risk may be considered when determining the rate which may be changed. The Capital Asset Pricing Model (CAPM) has been frequently used by investors to assess expected returns, so this may be applied to this case study.

CAPM is a tool which has been used to assess the retrain required on an investment, allowing for the existing market rates and the addition of a risk premium (Kevin, 2015; Reilly & Brown, 2011). The calculation for CAPM is Rj = Rf + (Rm x Bj) where Rj is the rate of return that is expected on any single stock (the cost of equity), Rf is the risk free investment rate, Rm is the additional equity risk premium and Bj is the beta. The first stage of the calculation is to assess the inputs needed for the calculation to take place. The risk free rate is assessed as being the rate at which it is possible to make an investment in a risk free environment (Kevin, 2015). Traditionally the costs of government bonds are used to determine the risk free rate. There is a degree of subjectivity here, as there are different bonds, here the one year rate will be used. The current one year rate is 0.62% (U.S. Department of the Treasury, 2016). The market risk premium is the mean rate of return achieved by the market (Kevin, 2015). Unfortunately, this may be subjective judgement due to different measures, uses different periods (Fernandez, 2015). Average market returns in the U.S. can vary greatly, for example between 1928 in 2014 the average return for an S&P 500 stock with 10% (Maverick, 2015). However, there is great volatility, and according to miniseries, including Warren Buffet, it is more realistic to expect an average between 6% to 7% per annum, which is drawn from the idea that over the long-term an economy may be expected to go to approximately 3% over inflation. If inflation averages 2%, this would create a return of 5%, dividend payments should improve on that, taking return to between 6% and 7% (Hamm, 2014). Therefore, the market return rate for the best 7% for the calculation. The last input is the beta (Reilly & Brown, 2011). It is commonly perceived to indicate this, although it is actually a measurement of volatility of the share price movements of a company compared to the marketplace (Bodie, Kane, & Marcus, 2014). Therefore, from the beta of what we say the same level of volatility as the stock market as a whole, often measured through the S&P 500. A 0.5 beta will be half of the volatility, and a beta of 2 will be twice the level of volatility of the stock market (Bodie et al., 2014). The beta for American Water is low… [END OF PREVIEW]

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