Question

Analyze and calculate the following scenarios in 525 words, including which one would you choose and why, and which financing option is best for your busines:

Investor #1 decided to loan you the $300,000, paying all of the interest (8% per year) and principal in one lump sum at the end of 5 years.

Investor #2 offers you the $300,000, paying interest at the rate of 8% per year for 4 years and then a final payment of interest and principal at the end of the 5th year.

Answer 1

Debt financing shall increase future liabilities which can be compared based on various factors such rate of interest, repayment obligations, tenor of loan etc. However in the given scenario rate of interest and principal is same, the difference lies in the repayment option. To evaluate the proposal in such cases, it is advisable to account for time value of money. Hence the present value of annual cash flows need to be compared to select between the two options. Since the discount rate reflects the future value of money, typically rates may be derived from consumer price index after adjusting for inflation and risk. The given cost of capital is 8%, the cash outflow can be discounted at the same rate for a period 5 years that is the duration of the loan. The following tables show the present value of cash flows for both options -

Investor 1- Year Principal outstanding Interest Payment PVF 8% PV CF 300000 300000 300000 300000 300000 24000 1.00 24000 0.93 24000 0.86 24000 0.79 24000 420000 0.74 Present value of loan payment 5 308712.54 308712.54 Investor 2- Year Principal outstanding Interest Payment PVF 8% PV CE 1.00 0.93 300000 300000 300000 300000 300000 24000 24000 24000 24000 24000 24000 24000 24000 24000 324000 0.86 0.79 0.74 24000.00 22222.22 20576.13 19051.97 238149.67 Present value of loan payment 324000.00

Based on the above analysis it is evident that present value of cash outflow is lesser in case of Investor 1 as compared to that of investor 2, hence it is advisable to select financing option from Investor 1.

However, for the purpose of selecting a loan plan for a business it is also important to evaluate the cash flows of the business and compare with the payment plan to identify feasibility of repayment of the financing option. Scenario 1 above allows payment in lump sum including interest at the end of year 5, whereas the scenario 2 allows for payment of interest element through the lifecycle of the loan. The business owner needs to prepare cash flows generated by the business so as to ascertain which payment obligation is better suited. Where a business might not have steady annual cash flow or incase the cash is tied up in cyclic working capital requirements of the business it will be difficult to meet payment obligations set out by Investor 2. Whereas the 1^st payment plan creates stress on cash flows in final year which might require extensive cash flow analysis and planning for that particular year, but at the same time in the final year of the project there is possibility of release of working capital or recovery from initial investment which might make this option more suitable to the business.

Other factors such as default penalty, mortgage, collateral requirement, tax implications, hidden cost, annual reporting and documentation should also be considered while comparing the two financing options.

Assumption- interest is not compounded annually.