Question

2) The Righton Corporation is taking out a loan of $16,500 at 8% interest (see table below). This interest rate is locked in for the life of the loan. They recognize that if when they want to take out another loan in the future, the interest rate may change, but they have no reason to expect it to be higher or lower, and they are confident that the bank would extend them another loan on similar terms. They are considering three different possible repayment plans for the current loan. Under Plan 1, they must pay yearly interest of $1,320 and the entire principal at the end. Plan 2 is an annuity-type plan where they pay equal payments of $2,459 every year. With Plan 3, they pay a balloon payment of principal plus all accumulated interest in year 10. Show how the bank calculates the balloon payment of 35,622. Planl Plan2 Plan3 16,500 16,500 16,500 -1,320 -2,4590 -1.320 -2,459 0 -1,320 -2,459 0 -1,320 -2,4590 -1,320 -2,459 0 -1,320 -2,459 0 -1,320 -2,459 0 1,320 -2,459 0 1.320 -2.459 0 10 -17.820-2,459 -35.622 payment sum:-29,700-24.590-35,622 NPV: ? ? ? What are the NPVs of the payment streams for the three plans? Can you use NPV to recommend one plan over the others? Why should one plan be preferred over another? Suppose that the company agreed on paying the 8% rate and signed a contract locking in that rate, and then the very next day the market interest rate dropped to 6%. Under which plan would the Righton Corporation be happiest? Under which plan would the bank be happiest? Why? How large would the gain or loss in NPV be for each plan?

Answer 1

A.1

A. 2

Year 0 1 2 3 4 5 6 7 8 9 10 NPV INTEREST RATE 8% PLAN 1 PLAN 2 Cash flow PV factor PV Cash flow PV factor PV Cash flow $ 16,500.00 1/ $ 16,500.00 $ 16,500.00 1 $ 16,500.00 $ 16,500.00 $ -1,320.00 0.925926 $ -1,222.22 $ -2,459.00 0.925926 $ -2,276.85 $ $ -1,320.00 0.857339 $ -1,131.69 $ -2,459.00 0.857339 $ -2,108.20 $ - $ -1,320.000.793832 $ -1,047.86$ -2,459.00 0.793832 $ -1,952.03 $ - $ -1,320.00 0.73503 $ -970.24 $ -2,459.00 0.73503 $ -1,807.44 $ - $ -1,320.00 0.680583 $ -898.37 $ -2,459.00 0.680583 $ -1,673.55 $ -. $ -1,320.00 0.63017) $ -831.82 $ -2,459.00 0.63017| $ -1,549.59 $ - $ -1,320.00 0.58349 $ -770.21 $ -2,459.00 0.58349 $ -1,434.80 $ - $ -1,320.00 0.540269 $ -713.15 $ -2,459.00 0.540269 $ -1,328.52 $ $ -1,320.00 0.500249 $ -660.33 $ -2,459.00 0.500249 $ -1,230.11 $ . $ -17,820.00 0.463193 $ -8,254.11 $ -2,459.00 0.463193 $ -1,138.99 $ -35,622.00 Ś $ -0.09 PLAN 3 PV factor PV 1 $ 16,500.00 0.925926 $ 0.857339 $ 0.793832 $ 0.73503 $ 0.680583 $ 0.63017) $ 0.58349 $ 0.540269 $ 0.500249 $ 0.463193 $ -16,499.88 $ 0.12

NPV is zero in all the three plans. Therefore, NPV cannot be used to recommend one plan over the other.

A.3

One plan should be preferred over the other based on the company's capacity and cash flows to pay the debt. If the company has to pay debt out of its earning then Plan 2 should be preferred as the payments are distributed equally over the life of the contract.

B.1

Righton Corporation will be happiest in Plan 2 because Plan 2 has the lowest negative NPV. (Refer table below)

B.2

The bank would be happiest in Plan 3 because Plan 3 has the highest negative NPV. (Refer table below)

Year 0 1 2 4 5 6 7 8 9 10 NPV INTEREST RATE 6% PLAN 1 PLAN 2 PLAN 3 Cash flow PV factor PV Cash flow PV factor PV I Cash flow PV factor PV $ 16,500.00 1 $ 16,500.00 $ 16,500.00 1 $ 16,500.00 $ 16,500.00 1 $ 16,500.00 $ -1,320.00 0.943396 $ -1,245.28 $ -2,459.00 0.943396 $ -2,319.81 $ - 0.943396 $ $ -1,320.000.889996 $ -1,174.80 $ -2,459.000.889996 $ -2,188.50 $ 0.889996 $ $ -1,320.00 0.8396191 $ -1,108.30 $ -2,459.00 0.8396191 $ -2,064.62 $ 0.839619 $ $ -1,320.000.792094 $ -1,045.56 $ -2,459.00 0.792094 $ -1,947.76 $ - 0.792094 $ $ -1,320.00 0.747258 $ -986.38 $ -2,459.00 0.747258) $ -1,837.51 $ 0.747258 $ $ -1,320.00 0.704961 $ -930.55 $ -2,459.00 0.704961 $ -1,733.50 $ - 0.704961 $ $ -1,320.00 0.665057 $ -877.88 $ -2,459.00 0.665057 $ -1,635.38 $ - 0.665057 $ $ -1,320.00 0.6274121 $ -828.18 $ -2,459.00 0.627412 $ -1,542.81 $ 0.6274121 $ $ -1,320.000.591898 $ -781.31 $ -2,459.000.591898 $ -1,455.48 $ 0.591898 $ $ -17,820.000.558395 $ -9,950.59 $ -2,459.000.558395 $ -1,373.09 $ -35,622.000 .558395 $ -19,891.14 $ -2,428.83 $ -1,598.45 $ -3,391.14

The NPV with 8% interest was zero. Therefore, the current NPVs represent the loss in each plan.