Assessment of a loan between Bank of America and American Water Works

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 at 0.199754 (Yahoo Finance, 2016). The input calculation it is not possible to assess the expected rate of return. The calculation is as follows;

Risk free rate

Market return

Beta

Expected return

0.62

7

0.19975

2.018278

This indicates that an expected rate of return for the lender would be 2.018278%, which can be rounded to 2.02%. However, it may be argued that this be through a lender, as it is based on a very low level of volatility associated share price, which may not give a true representation of the risk associated with the loan, or the risk inherent in the company's business operations (Fernandez, 2015). Therefore, it is possible a higher rate would be required.

With a long-term rate, and interest rates currently low, expected to rise, it is highly unlikely that borrower would be able to gain a loan a fixed rate for a 10-year period. Offering a loan at this rate would be unwise for lenders, as rises in interest rates could result in depositors requiring a higher return, which may leave little, or even a potential negative returns for the bank for the net interest received (Watson, 2014). Therefore, it is also assumed that the loan is a variable rate loan, with changes in interest rates being implemented to reflect the changing market conditions. This paper, it is assumed that the interest rate for the loan remains at 2.02%, and there are no additional transaction costs.

5. Impact on Lender

A loan of this type will have both positive and negative impact on the lender. Firstly, the lender in the business of making loans, therefore, the loan will result in an increased level of revenue generated for the firm. The bigger interest the bank the net interest inflow, this is the amount of interest that is received after they have paid interest on the deposits used to fund the loan (Bridges et al., 2014; Morais, Peydro, & Ortega, 2015). Current deposit rates will vary for different consumers and businesses, with some deposits attracting a zero rate, others may attract a more positive way, but they will remain low. Therefore, it is assumed that the average deposit rate paid out by the lender in 0.5%. Using the assumption, the calculation for the net interest received per annum is shown below.

Loan amount

15,000,000

Interest rate paid by borrower

2.02%

Gross interest received

303,000

Less interest paid to depositors

75,000

Net interest received

228,000

Therefore, the Bank of America will receive a net interest payment every year of $228,000, over a period of 10 years. This results in inflows of $2.28 million over a ten-year period. However, the time value of money will erode the value of that inflow during the forthcoming decade.

By making this loan the organisation maintains a piece of administrative efficiency. While transaction costs are not considered within the assessment, it is fair to assume that commending a similar amount of money to a number of other borrowers, would involve a higher level of associated overheads (Kevin, 2015). Therefore, the potential for increased efficiency in the lending process were the Bank of America makes a single large loan, rather than multiple smaller loans.

When a bank makes a loan, it also impact on the overall capital adequacy. Capital adequacy is determined through the application of the Basal Accords, with new levels under the Basel III agreement being implemented by 2019, as well as requirements issued by the Federal Reserve (Bridges et al., 2014). In order to protect the financial system and relevant stakeholders, banks have limits on how much money they can lend based on the amount of assets they hold. The implemented tighten the ability of companies such as the Bank Of America to expand lending, for example, the minimum common equity requirement is being increased by 2.5%, from 2% to 4.5% of assets (Ghosh, Sugawara and Zalduendo, 2012). In addition, the regulations create a conservation buffer which is 2.5% of assets, resulting in a core tier 1 capital requirement of 7% (Gosh et al., 2012; Harle et al., 2010). The broader tier 1 requirement is 8.5%, with a 1.5% minimum for additional noncore tier 1 capital (Harle et al., 2010). Additional requirements were also introduced in terms of the standards set for short-term funding and long-term funding (Harle et al., 2010). The increase in capital requirements is significant, with the initial implementation date of 2015 being extended to 2019 (Yan et al., 2012). This means that a single loan of $15 million may present a significant opportunity cost to the organisation (Nellis & Parker, 2006), preventing lending undertaken elsewhere., The Bank of America has tier 1 risk-weighted assets of $1,602 billion, and a common equity tier ratio of 10.2% (Bank of America, 2016). Therefore, the bank is already in compliance with forthcoming requirements. However, increasing lending by 15% will inevitably impact on this ratio, but the size of the current loan book, means that the impact will not be significant.

The main impact on the supplier may be the opportunity cost associated with lending to American Water. With a very low level of risk, the loan attracts a relatively low level of interest. It is possible that the company could gain a better return, even allowing for additional overhead, if money was lent to organisations, or individuals, where there is a greater premium. This is particularly pertinent in the case of this low, due to the calculation of the interest rate using a significantly lower than average beta. For example, the current interest rate on SBA 7A loans in the United States, for amounts above $50,000 is 5.75%. This can be used to assess the potential opportunity cost if the organisation chooses to lend to American Water, rather than to lend to a more lucrative set of borrowers.

American Water

SBA 7A

Loan amount

15,000,000

15,000,000

Interest rate paid by borrower

2.02%

5.75%

Gross interest received

303,000

862,500

Less interest paid to depositors

75,000

75,000

Net interest received

228,000

787,500

Difference

559,500

This calculation shows that if the bank chose to lend to other borrowers that interest receipts could be approximately $559,500 more per annum, or $5.5 million over the term of the loan. However, this would also increase overall risk, not only do the higher risk borrowers, even if they are assessed to be standard with, but the diversity within the portfolio spread of numerous loans.

This potential for risk also highlights the way in which the bank may require some type of security so that the capital may be recovered in case of a default (Morais et al., 2015). It is usual for firms to offer some type of security, this may be in form of equity holdings for the bank, but it is more frequently a charge over some type of asset (Richards, Palmer, & Boganiva, 2008). The type of security will depend on the type of loan, and its purpose. For example, working capital financing may result on a floating lien on inventories, which may be seized if the borrower defaults (Clarkson, Miller, & Cross, 2010). For larger loans, such as that are being made to American Water, waited for the creation of assets, such as buildings, a charge may be taken on the real estate which is created/enhanced (Clarkson et al., 2010). This ensures that the organisation has first claim on a specific asset if there is a default. Therefore, it is highly recommended that the bank ensure that they have sufficient security to cover the loan, as well as facilitate a potential decrease in value of the underlying asset.

In addition to security, the bank may also wish to protect his position by implementing terms and conditions into the loan agreement (Clarkson et al., 2010). For example, in order to ensure the organisation is able to continue to repay its existing debts, and reduce the risk to the firm, a term regarding a limit on the level of debt the organisation can acquire may be inflated. This is usually implemented through a debt ratio agreement, where the organisation does not exceed a specific level of debt to equity, or debt to assets. The loan will not impact on the firm's own debt-to-equity ratio, as this is an operational transaction, with the loan being made out of current liabilities in the tender deposit, and the debt itself being an asset. The ratio for times interest earned will see a positive return. As interest is seen as a general operating expense, deducted from the revenue before it interest is declared, it is not possible to calculate the impact of the loan on times interest ratios (Elliott & Elliott, 2013). Likewise, the bank deals in the, rather than inventories, the level of impact are working capital will be minimal. However, making the loan may impact on the return on assets, as the loan itself is an asset. Currently, the return on assets 0.68%, as the net return gained in excess of 1.5% loan, the return on assets will increase, but the overall impact is minimal due to the large portfolio of loans made by the bank, and may be impacted not only on the number of loans outstanding, but the differential interest rates attached to relevant lines. The current return on equity for the bank is 6.29%. Making the loan not impact on the level of equity in short-term, although creating further earnings which may be retained will support increased levels of equity. Therefore, operations which will increase the overall level of earnings or inherently impact positively on the return on equity. Ratios such as asset turnover are weak within the banking sector, as it is money rather than physical assets which are important, as seen with the current total asset turnover 0.04 ratio. A long-term loan, increasing revenues, a how to improve this ratio very slightly, but it is unlikely to provide any statistically significant change. The earnings before interest tax and depreciation will increase, and therefore increase the profit margin.

6. Impact on Borrower

The impact on the borrower will also be both positive and negative. By borrowing the funds, the company will be able to make further investments, which is assessed correctly using tall such as net present value, with future cash flows discounted into today's value, and opportunity costs assessed, should create a positive return for the company (Reilly & Brown, 2011). For example, it is expected that the investment into the desalinated plant, as well as renewal of piping, will not have any benefit in year 1, but result in gains of $2.5 million in years 2 to 3, and then $4 million per annum up until year 10, after allowing for interest payments, it is possible to assess the real value of the investment. To determine this, a net present value calculation will be undertaken, and shown below. The net present value calculation shown below.

Year

Profit

discount rate discounted cash flow

Accumulative total

Year 1

0

0.98039216

0

0

Year 2

2,500,000

0.96116878

2,402,922

2,402,922

Year 3

2,500,000

0.94232233

2,355,806

4,758,728

Year 4

4,000,000

0.92384543

3,695,382

8,454,109

Year 5

4,000,000

0.90573081

3,622,923

12,077,033

Year 6

4,000,000

0.88797138

3,551,886

15,628,918

Year 7

4,000,000

0.87056018

3,482,241

19,111,159

Year 8

4,000,000

0.85349037

3,413,961

22,525,120

Year 9

4,000,000

0.83675527

3,347,021

25,872,142

Year 10

4,000,000

0.8203483

3,281,393

29,153,535

Less initial investment

15,000,000

NPV

14,153,535

This shows that the net present value of the project over a ten-year period will be $14 million, and therefore provide a positive return. This would appear to be a good investment. However, when borrowing the money, there will also need to assess the potential impact it will have on the organisation as a whole, not only the immediate cash flow, but the knock-on effect on different ratios, which may influence other investment, borrowing, lending, or operating decisions.

Firstly, net profit for American Water, after interest, will decrease by $228,000 per annum. The increased interest costs would reduce the taxation payable, as interest payments are tax deductible, but would have an overall negative impact on the revenue, the impact depending upon the marginal tax paid by the organisation.