WSMC STATE TEAM PROBLEM 1998
The Bank Loan Experience
You are an accounting manager for a company that is starting a new 'spin-off' segment of business and needs to borrow the capital necessary to start this new venture. Your task is to analyze all of the loan options, and prepare a report for the Board of Directors that details the impact of each option and makes a recommendation as to the course of action. The report should contain any text, diagrams, charts, tables, and/or graphs that will help the Board members clearly understand the options and the rationale behind your recommended course of action.
Your company will need to borrow a total of $25,000 over a 10 year period. It will be necessary that you borrow $10,000 immediately, another $7000 three years from now, another $5000 five years from now, and finally $3000 seven years from now. You want to be finished paying back all of the borrowed money at the end of 10 years. The following options, and only these, are available:
Option 1: Total amount immediately
In this option you borrow the total amount you need to finance ($25,000) immediately and simply make equal monthly payments for the total loan duration of 10 years. The interest rate is 12% per year, and your friendly banker is willing to make this loan to you.
Option 2: Sequential Loans
In this option, you will only borrow the amount you need immediately, and will pay back that amount by the time you need the next loan. That is, you will borrow $10,000 immediately and pay it back over the first 36 months (equal monthly payments), then borrow $7,000 for 24 months, and so on. Although this means more paperwork for the bank, they will still be glad to make the loan in this form at the same rate of 12% per year.
Option 3: Refinanced Loans
In this option you take out each loan as you need it and compute your monthly payments as if the loan were to last for the entire given period. Each time you need to borrow an additional amount you would combine the existing balance of the loan plus a refinance charge of 5% and the new loan amount. You then must recompute the monthly payment for this new loan. Thus, you would make payments on the first loan of $10,000 for 36 months at a monthly payment amount that would pay back that amount in ten years. At the end of 36 months, you would add the existing balance of the first loan and the refinance charge together with the second loan amount ($7,000). Then recompute the monthly payment for that total to be paid back in seven years, and make that payment for 24 months. Then you would repeat the process for the third loan, and 24 months later once more for the final loan. The bank will maintain the 12% interest rate per year, but will add a refinance charge of 5% of the existing balance each time a refinance occurs (at 36 months, 60 months, and 96 months).
Option 4: Declining balance (the credit card model):
In this option you simply borrow as much as you need whenever you need. Each month, a finance charge is added (monthly interest on the current balance), your monthly payment is deducted, and an amount of additional loan (if any) is added to form a new balance. Using this option, you would pay on the first loan ($10000) monthly for 36 months, then would add the second loan ($7000) and pay on the combined amount for the next 24 months, and so on for the ten year period. You do not need to negotiate with a banker do this option, since your credit card is at your disposal and has an initial balance of $0. The interest rate is 18% per year, and the credit limit of $15,000 cannot be exceeded at any time.
The amortization formulas that you (and the bank) use in computing options 1, 2, and 3 are:
| M = | r[Ak - A0(1+r)k] | and | Ak = | M[1 - (1+r)k] | + A0(1+r)k | |
| 1 - (1+r)k | r |
where:
| M =
the monthly payment amount r = the interest rate per month k = the month number:
|
A0
= the initial amount borrowed Ak = the existing loan balance after the kth month
|
The amortization formula for Option 4 is:
Ak = A(k-1)[1+r] - P + N
where:
| k =
the month number r = the interest rate per month Ak = the curret monthly amount
|
P =
the monthly payment amount N = any new loan amount added (7000, 5000, 3000) |
Your report to the Board of Directors should include, a minimum of the following:
1. For options 1, 2, and 3
a. Use the summary sheet to report the principle, monthly payments, and number of payments over the entire 10 year period, the total amount paid, total interest paid, and the average monthly payment. (Label and use the additional columns on the summary sheet as needed to organize your work.)
b. Use graph paper to display a separate graph for each option. The graphs should record the remaining balance as a function of time over the 10 year period.
2. For option 4:
a. Determine what constant monthly payment to the nearest dollar, would be needed to pay off all of the loans at the end of the 10 year period. (HINT: The amount of the average monthly payment necessary to pay off the loan in 10 years is between the lowest and highest average monthly payments you computed for Options 1, 2, and 3.)
b. Construct a summary sheet to report the principle, monthly payments, and number of payments over the entire 10 year period, the total amount paid, total interest paid, and the average monthly payment.
3. Analysis of loan options:
a. Based on your computations, loan summary sheets, and graphs discuss at least one advantage and one disadvantage for each of the four options;
b. Recommended course of action:
c. Rationale for your recommended course of action.