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Returns Estimating and Refinancing Decisions
Part 1 – Estimating Returns
In the given scenario where the company estimates three possible economic outcomes: poor, average, and above-average. In each case, the company speculates a probability of occurrence of 20%, 40%, and 40% respectively. Further, the company also forecasts the possible returns for each possible economic outcome at 10% for a poor economy, 18% for an average economy, and 30% for an above-average economy.
Calculation of expected returns
Given these scenarios, we can estimate the expected returns for the company. The expected returns are calculated for each expected economic forecast and then summed to give the expected returns for the company. This data is tabulated below.
| Expected return | |||
| Scenario | Probability | Possible returns | ER |
| Poor economy | 20% | 10% | 2.0% |
| Average economy | 40% | 18% | 7.2% |
| Above-average economy | 40% | 30% | 12.0% |
| Expected return: | 21.2% |
Returns Estimating and Refinancing Decisions
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Calculation of standard deviation
In addition to the expected return, we can also calculate the standard deviation. In a similar fashion to the expected return calculations, the calculation of the standard deviation involves calculation for each economic forecast and a square root of the summation of the same to indicate the forecast for the company. These calculations are tabulated below.
| Standard deviation | ||||
| Scenario | Probability | Possible returns | SD | |
| Poor economy | 20% | 10% | 0.25% | |
| Average economy | 40% | 18% | 0.04% | |
| Above-average economy | 40% | 30% | 0.31% | |
| 0.60% | ||||
| Standard deviation: | 7.76% |
How the standard deviation helps better understand what to expect in terms of a return
The standard deviation is useful in the understanding of a return, and in particular the volatility of the return. The standard deviation of the return is a measure of how much the actual return deviates from the expected return. A high standard deviation value implies an increase in the volatility of the company (Gibson, Michayluk, & Van de Venter, 2013). This high level of volatility suggests a higher risk level for the firm.
Returns Estimating and Refinancing Decisions
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Part 2 – Deciding on refinancing
The scenario that requires a decision on whether to refinance the current loan facility is outlined below.
| Current loan details: | |
| Principal (Mortgage value) | $100,000 |
| Interest | 7% |
| Years left | 14 |
| Negotiated (years ago) | 2 |
| Closing costs | $2,000 |
| Amount to be repaid: | $98,000 |
| $200,000 |
Upon refinancing, the new terms change to those in the table below.
| Refinancing: | |
| Interest | 5.50% |
| Years left | 15 |
| Closing costs | $1,500 |
| Amount to be repaid: | $82,500 |
| $184,000 |
Returns Estimating and Refinancing Decisions
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The decision and reasons to refinance
Given the two scenarios above, I would decide the refinance the loan facility. The main reasons behind this decision would be the fact that the amount to be repaid reduces with the refinancing. In addition, the period remaining to pay back the loan facility increases with the decrease in the interest rate payable per year.
Qualitative considerations to consider in the decision to refinance or not refinance
Prior to considering a decision on whether or not to refinance a loan facility, several qualitative considerations are made. These considerations include whether the amount payable decreases or not. A second consideration is whether the payback period for the loan changes upwards or downwards. A third consideration is whether the interest rate reduces or increases with the refinancing. A fourth consideration is whether there is a change in the closing costs associated with the loan facility (Parameswaran, 2011).
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Calculations to help you make the decision to refinance or not to refinance
The sample calculations tabulated above help guide the decision on whether to refinance or not to refinance. In the current loan terms, the amount to be repaid is $98,000. This is calculated using the formula below.
Amount payable =Principal * Interest rate * Number of years
The total amount payable is the sum of the amount payable ($98,000), the closing costs, and the principal amount. The sum of these figures comes to $200,000.
The refinancing scenario terms alter these terms by increasing the number of years, reducing the interest rate, and decreasing the closing costs. As such, the refinancing satisfies three of the qualitative considerations. In order to test for the fourth qualitative consideration, we apply the same formula to the loan facility using the new terms of the refinancing (Brigham & Houston, 2016). In this case, the amount payable comes to $82,500 and the total amount payable is $184,000.
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Therefore, given the reduction in the total amount payable from $200,000 to $184,000, as well as the satisfaction of the qualitative consideration for a refinancing, a refinancing is a better option in this case compared to not refinancing.
References
Brigham, E. F., & Houston, J. F. (2016). Fundamentals of financial management (14th ed.). Boston, MA: Cengage.
Gibson, R., Michayluk, D., & Van de Venter, G. (2013). Financial risk tolerance: An analysis of unexplored factors. Financial Services Review, 22(1), 23–50.
Parameswaran, S. (2011). Fundamentals of financial instruments: Stocks, bonds, foreign exchange, and derivatives. Hoboken, NJ: John Wiley & Sons.
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