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Homework answers / question archive / ABC Corporation is determining whether to support $150,000 of its permanent current assets with a bank note or a short-term bond
ABC Corporation is determining whether to support $150,000 of its permanent current assets with a bank note or a short-term bond. The firm's bank offers a two-year note where the firm will receive $150,000 and repay $175,000 at the end of two years. The firm has the option to renew the loan at market rates.l Alternatively, ABC can sell 8.5% coupon bonds with a 2-year maturity and $1,000 par value at a price of $973.97. How many percentage points lower is the interest rate on the less expensive debt instrument?
Option 1 - Bank note - Here the amount borrowed in 150,000 and the amount repaid is 175,000 in 2 years. The difference is the interest that is paid. So over 2 years we pay 25,000 as interest. The compound interest formula is:
Compound Interest = PX(1+r)^n - P
Here Compound Interest = 25,000
P=150,000
n=2 and we have to find r. We ge
25,000= 150,000X(1+r)^2 - 150,000
175,000/150,000=(1+r)^2
(175,000/150,000)^(1/2)=1+r
r=8.0%
Option 2 - Sell bonds - Here the interest rate is the yield to maturity (YTM) on bonds. The YTM is the discount rate that will make the present value of interest and principal equal to the price today. The interest amount is 85, principal is 1,000, period is 2 years and the price is 973.97. Interest amount is an annuity and the principal amount is a lump sum. We get:
973.97 = 85 X PVIFA (2years, r%) + 1,000 X PVIF (2 years, r%)
We can find r using trial and error or use the RATE function in excel. Using the RATE function input Nper=2, Pmt=85, PV=-973.97, FV = 1,000. This gives the rate as 10%.
The less expensive option is bank loan and the rate is 2% lower.
