Sanders Co. is planning to finance an expansion of its operations by borrowing $54,100. City Bank has agreed to loan Sanders the funds.

Sanders Co. is planning to finance an expansion of its operations by borrowing $54,100. 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  $5,410 of the principal each year along with the annual interest based on the unpaid principal balance. Assume the interest rate is 9.5 percent for each option.


Required
a.    What amount of interest will Sanders pay in year 1 under option 1 and under option 2?

Explanation:

a.

Year 1:

Option 1 − annual interest only:

$54,100 × 9.5% = $5,140

   

Option 2 − annual interest and $5,410 on principal:

$54,100 × 9.5% = $5,140

   

Note: The amount of interest paid in year 1 is the same under both options because no payment was made on the principal until the end of the year under option two.

b.

Year 2:

Option 1 − annual interest only:

$54,100 × 9.5% = $5,140

   

Option 2 − annual interest and $5,410 on principal:

  

Original principal:	$	54,100
Less: Payment at end of year one		(5,410	)
Balance of principal for year two	$	48,690

   

$48,690 × 9.5% = $4,626

Note: Under option two, less interest will be paid in year two and in future years because the amount subject to interest is less.

c.

Under option one, only annual interest is paid. This is a desirable option if a company expects cash flow problems in the early years. More interest will be paid, but less cash is required in the short term. Option two is more advantageous if the business has enough cash to pay both principal and interest each year. This option is less costly.

Thank you!