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

Solution:-

The purpose a businessman raises debt as source of finance for his business is because he is confident that the investment in his business is going to generate higher returns than the interest payable on debt (which makes raising debt a viable option) and would ideally leave him with enough free cash flows over the tenure of the debt to pay back principal on maturity.

In other words, the core point that makes raising debt a good option is the ability of business to generate ROIs (Returns on investment) higher than the cost of carrying debt.

In the given situation, the businessman has two options which are described as follows:

1) The option to raise 5-year debt at 8% p.a. interest rate with cumulative interest for all 5 years payable at the end of the loan tenure along with principal repayment.

2) The option to take 5-year loan at the same 8% p.a. interest with interest payments to be made on annual basis and principal to be repaid at the end of 5 years along with the interest for 5th year.

Analysis of first option and effects of compounded interest:

In the first option, there is an option to pay interest for all years combined at the end of loan tenure. This means that as the interest for an year accrues during that year, it will get added to the principal outstanding of the loan and the business will have to pay interest on that increased outstanding amount (i.e. principal + accrued interest) during the remaining tenure of the loan. This is a classic example of compounded interest.

Let's analyze option 1 with the help of a table:

	Year 1 end	Year 2 end	Year 3 end	Year 4 end	Year 5 end
Opening principal	300,000	324,000	349,920	377,914	408,147
Interest accrued for the year (Opening principal*8%)	24,000	25,920	27,994	30,233	32,652
Interest paid during the year	-	-	-	-	-
Closing principal (Opening principal + accrued interest - interest paid)	324,000	349,920	377,914	408,147	440,799

Therefore, at the end of year 5, the business will pay the cumulative interest for all years and principal amounting to $440,799. The total interest paid in option 1 is $140,799 (i.e. calculated as 440,799-300,000).

Analysis of second option:

	Year 1 end	Year 2 end	Year 3 end	Year 4 end	Year 5 end
Opening principal	300,000	300,000	300,000	300,000	300,000
Interest accrued and due (Opening principal*8%)	24,000	24,000	24,000	24,000	24,000
Interest paid	24,000	24,000	24,000	24,000	24,000
Closing principal (Opening principal + accrued interest - interest paid)	300,000	300,000	300,000	300,000	300,000

Therefore, at the end of year 5 the business will repay back the principal of $300,000. The total interest paid during 5 years is $120,000 (i.e. 24,000*5years).

Which option is better?

As discussed earlier, the whole premise of taking a loan is that the business can generate higher ROIs than the cost of debt. In case 2 the business will have to pay interest on an annual basis which will result in annual cash outflows from year 1 to year 5. The total interest payments in option 1 is $120,000.

On the contrary, the option 1 gives an opportunity to pay back all interest cumulatively at the end of year 5. While, this means that the effects of compounded interest pushes total interest payable at the end of year 5 higher to $140,799, it is still a better option because the annual cash outflows of interest which are prevented this way will then be invested in business which will generate returns higher than 8% which is the cost of keeping funds in the business.

This means that though total interest payable in option 1 is higher than option 2, but still option 1 is better and hence must be chosen.