Can someone help me solve this You have $25,000 in the bank, in a savings account that draws 5 percent interest. Your business needs $25,000, and you are considering two options: (a) Use the money in your savings account or ( b) borrow the money from the bank at 6 percent, leaving the money in your savings account. Your financial analyst suggests that solution (b) is better. His logic: The sum of the interest paid on the 6 percent loan is lower than the interest earned at the same time on the $25,000 deposit. Show that this logic is wrong. (If you think about it, it couldn’t be preferable to take a 6 percent loan when you are getting 5 percent interest from the bank.
Hypothetical—>asuming a baloon payment on the loan you are required to pay 1500 each year. You earn 1250 in the savings account currently…BUT you forget compounding If you can wait to withdraw money–>In 4 years you are making more on your savings account than you are paying on your loan…even if you begin to withdraw the money you will still net something like $20. I hope that helps, unless I, myself, am confused?!
I would say it depends on what the funds are used for. This seems like a textbook coroporate finance/IRR problem.
Loan period is for 2 years. i found this problem in Benninga chp 1.
aquabu Wrote: ------------------------------------------------------- > Loan period is for 2 years. i found this problem > in Benninga chp 1. any tax consequences?
Is this an installment note? or a balloon payment at the end? The bank borrowing I mean
payments are in installments @ End of Year for 2 years. that comes out to $13,635.92 / year
For an opportunity cost of 1% they are keeping a balance of $25,000 in the bank. In this economy, cash and liquidity is a huge asset. Perhaps this is the reasoning the analyst has.
We can discount the benefits of liquidity, debt financing, etc.If you purely consider the figures alone which would be the best way of financing the project. according to the author, we have to prove the anlyst wrong.
Year | amt in bank| pmt for loan| EOY amt | int (5%) 1| 25000 | $13,635.92 | $11,364.08 |1250 2| $12,614.08 | $13,635.92 | ($1,021.84) | 630.7038835 i think this is the answer. since at the End of Year 2 the value in the bank account is -ve, the analyst is wrong.
$25,000 left in bank at 5% ~at end of year 1: $26,250 ~at end of year 2: $27,562.50 $25,000 loan, 2 years at 6% ~installment: 2 payments of $13,635.92 Total: $27,271.84 $27,562.50 - $27,271.84 = $290.65
CFA_Tool, how are you going to finance the loan? you have to consider the oppurtunity cost of that financing right? i am assuming that i am going to payout my loan from my bank account itself in which case the analyst is wrong
I GOT IT!!! the payments are 13635.9 at 6% a year…BUT…your opportunity cost is 5%. So if you would discount those payments at your opportunity cost (which is what should be the hurdle rate) then you get a PV of 25354.7!!! That is greater than the 25k in your bank account. So answer A is the answer! Anyways…I think that might be the answer?!?
If you use your BA to fund the project, your cash balance is 0. If you borrow $25K @ 6% and repay loan with BA: Year 1 Beg. Bal 25000 Acc Int on BA 1250 End. Bal 26250 Payment -13635.92 End Cash 12614.08 Year 2 Beg. Bal 12614.08 Acc Int on BA 630.704 End. Bal 13244.784 Payment -13635.92 End Cash -391.136 By borrowing, you have a negative cash balance in 2 years. By using your BA, you have a 0 balance.
that’s the answer !!
Hey by the way my answer works too…he found the FV i found the PV…354 at the opp cost of 5% for 2 years equals 391.136
The problem says to show that it is better to use the money in the savings account and lose 5% interest rather than to borrow at 6%. The financial analyst suggests that the interest payments you will pay on a 6% loan will be less than the 5% you get in the savings account. Presumably the reason that paying 6% on 25k would be less than earning 5% on 25k is that there is compounding on the 5% that gets you at least 1% more net. I’m not sure that’s true, unless perhaps it’s continuously compounded (I’m too lazy to break out my calculator and check, but you’d compare exp(0.05) to 1.06. I think the key is probably that during year 2, your bank account is earning 5%, but the balance on it is about 1/2 - 6% because you paid off one loan installment. This means that even though the second year of the interest payments is on only half as much, the 5% interest on the bank account is based on a lower amount too. The real trick of the problem is to try to find out 1) what erroneous calculation the analyst did, and 2) why it’s erroneous. That’s a strange problem, since you can probably find a ton of erroneous ways to do things, and also bad pedagogy, since you’ll be practicing lots of wrong ways to do things while you’re trying to find the solution. Very odd. BTW, aquabu, nothing personal intended here, but I’m finding it really really annoying to read “-- A stitch in time saves nine --” after all of your posts. I don’t know if anyone else reacts that way too.
This reminds of an personal finance article that I read which argued that it would be better to put your money in a savings acct earning a lower rate than paying off debt w/ a higher rate from a purely financial standpoint. They went tried to prove it with maths…
To make it simple, the opportunity cost of using the money in the bank is 6% ( the foregone interest). The cost of taking the loan is 6%. Since 5% < 6%, use the bank money.