Question

Sanders Co. is planning to finance an expansion of its operations by borrowing $51,500. City Bank has agreed to loan Sanders the funds. Sanders has two repayment options: (1) to issue a note with the principal due in 10 years and with interest payable annually or (2) to issue a note to repay $5,150 of the principal each year along with the annual interest based on the unpaid principal balance. Assume the interest rate is 8 percent for each option.
Required:
a. What amount of interest will Sanders pay in Year 1 under option 1 and under option 2?
b. What amount of interest will Sanders pay in Year 2 under option 1 and under option 2?

Answer 1

Answer:

A. Year 1 Option 1 $4,120

Year 1 Option 2 $4,120

B. Year 2 Option 1 $4,120

Year 2 Option 2 $3,708

Explanation:

A. Calculation to determine What amount of interest will Sanders pay in Year 1 under option 1 and under option 2

Year 1:

Option 1 − annual interest only=$51,500 × 8%

Option 1 − annual interest only= $4,120

Option 2 − annual interest

Option 2 − annual interest =$51,500 × 8

Option 2 − annual interest = $4,120

Therefore amount of interest will Sanders pay in Year 1 under option 1 and under option 2 is :

Year 1 Option 1 $4,120

Year 1 Option 2 $4,120

B. Calculation to determine What amount of interest will Sanders pay in Year 2 under option 1 and under option 2

Year 2

Option 1 − annual interest only=$150,000 × 8%

Option 1 − annual interest only= $4,120

Option 2 − annual interest and $5,150 on principal:

Original principal $51,500

Less: Payment at end of year one ($5,150)

Balance of principal for year two $46,350

Option 2 − annual interest= $46,350 × 8%

Option 2 − annual interest= $3,708

Therefore amount of interest will Sanders pay in Year 2 under option 1 and under option 2 is :

Year 2 Option 1 $4,120

Year 2 Option 2 $3,708