Question

5(a) A company is discussing a $0.5 million loan with a bank. The interest rate is 12% compounded annually and the repayment period is 5 years. The bank is offering two options for loan repayment: Option A: Payments are to be received in equal installments at the end of each year. Option B: Interest is to be received on a yearly basis and the Principal is to be receivedat the end. All loan repayment items are end-of-year payments. Which options is better for the company?

Answer 1

Answer:

Option A)

First of all lets calculate Installment amount

Installment amount = Loan/PVIFA(r%,n)

=500000/PVIFA(12%,5 years)

=500000/3.6047

=138705$

Statement showing repayment schedule

			Towards
Year	Opening balance	Installment	Interest @ 12%	Principal	Closing balance
1	500000	138705	60000	78705	421295
2	421295	138705	50555	88150	333145
3	333145	138705	39977	98728	234418
4	234418	138705	28130	110575	123843
5	123843	138705	14861	123844	0
			193524	500000

Thus total Interest = 193,524$

Option B)

Statement showing repayment of principal and Interest

Year	Interest payments	Principal payment	Total
1	60000		60000
2	60000		60000
3	60000		60000
4	60000		60000
5	60000	500000	560000
Total	300000	500000

Here Interest is 300,000$

Since Interest payment in option A is less than option B. Option A is preferable