Rosetree Mortgage Opportunity Fund Case Study Solution
Valuation:
Net Present Value (NPV) and WACC:
Net Present Value (NPV)is defined as a valuation method that is used to analyze the viability of the proposed project or investment. This method reveals the absolute gain which will be earned from the project or investment. To calculate the NPV of a project, the associated inflows and outflows of the project have been taken and then discount them using the WACC of the company.
To calculate the WACC for the firm the risk free rate has been taken by using the yield of 6 months treasury bills of the United States while for the beta of the company.The debt to equity ratio of the firm has been used to find the comparable company in the list of competitors in order to use its un levered beta to convert in the firm’s levered beta. By using this, two competitors have been selected which are Colonial properties trust and Home properties incorporation. The weighted average of these two competitors has been taken in order to calculate the levered beta for the firm. The weighted average first maximum increase has been taken the market risk premium for the company because it is showing an increase in the loan portfolio. Calculations for WACC are shown in Exhibit 11 of the document.
If Rose Tree Mortgage Opportunity Funds invest $65 million in loan portfolio then the organization will earn principle, interest, and liquidation until 30 years however the company has to incur servicing expense till the maturity. Along with this as there is uncertainty in relation to the economy, therefore,the organization identifies four scenarios which are slow economic growth, moderate recession, severe recession and severe recession with loan renegotiation option.
The NPV of the loan will be 10.17 million dollars, 13.76 million dollars, -21.37 million dollars and 11.82 million dollars under slow economic growth, moderate recession, severe recession and severe recession with loan renegotiation options respectively which can be seen in Exhibit 2 of the document.
Internal Rate of Return:
Internal Rate of Return (IRR) is the other method that is used to analyze the viability of the proposed project or investment. This method reveals the point or discount rate at which the inflows and outflows of the project or investment become the same in other at which the NPV of the project becomes zero.
Using the investment of $65 million and projected cash flows, it has been determined that the IRR of the investment will be 13 %, 15 %, -6 % and 14 % under slow economic growth, moderate recession, severe recession and severe recession with loan renegotiation option respectively which can be seen in Exhibit 2 of the document.
Recommendation and Offer Price:
From the qualitative analysis, we will recommend that the company should purchase these loans as the FICO rate is approximately in line with the FICO rate of the Subprime pool.Moreover, the LTV of the loans is lower than the normal range of 80%. However, the quantitative analysis reveals that if the company purchases this loan at $65 million then the value of NPV will be positive under all the scenarios except the severe recession. Along with this, the IRR of the loan will also is in line with the targeted range of the company except under the scenario of the severe recession. Therefore, it will be recommended to the firm that it should purchase the loan at this amount.
However, the recommended offering price for the company must be the price ranges between 43.67 million dollars to 76.85 million dollars otherwise they will lose their investment and its value.
Exhibit 1: WACC Calculations
| Risk-Free Rate | 0.90% |
| Total Asset | 325,169,736 |
| Total Debt | $65,033,948 |
| Total Equity | 260,135,788 |
| Debt to equity | 25% |
| Equity to Asset | 80% |
| Debt to Asset | 20% |
| Unlevered Beta | 1.48 |
| Levered Beta | 1.18 |
| Market Risk Premium | 5.4% |
| Cost of Equity | 7.29% |
| Cost of Debt | 7.00% |
| WACC | 7.23% |
Exhibit 2: Offering Price Calculations
| Initial Inv | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | NPV | IRR | |
| Cash flows from slow economic growth | (65,034) | 18,457.10 | 18,457.10 | 18,457.10 | 18,457.10 | 18,457.10 | $10,170.24 | 13% |
| Cash flows from moderate recession | (65,034) | 19338.1 | 19338.1 | 19338.1 | 19338.1 | 19338.1 | $13,759.91 | 15% |
| Cash flows from severe recession | (65,034) | $10,717.20 | 10717.2 | 10717.2 | 10717.2 | 10717.2 | ($21,366.29) | -6% |
| Cash flows from severe recession with loan renegotiation | (65,034) | $18,861.60 | 18861.6 | 18861.6 | 18861.6 | 18861.6 | $11,818.39 | 14% |
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