11. Bank loans Aa Aa Short-term financing through bank loans Consider this case:
ID: 2791794 • Letter: 1
Question
11. Bank loans Aa Aa Short-term financing through bank loans Consider this case: Clancy and Smith Corp. needs to take out a one-year bank loan of $450,000 and has been offered loan terms by two different banks. One bank has offered a simple interest loan of 996 that requires monthly payments. The loan principal will be paid back at the end of the year. Another bank has offered 6% add-on interest to be repaid in 12 equal monthly installments. Based on a 360-day year, what will be the monthly payment for each loan for November? (Hint: Remember that November has 30 days.) Value Simple interest monthly payment Add-on interest monthly payment Choose the answer that best evaluates the following statement: A bank loan officer has been approached by a start-up company that needs a five-year loan to purchase the equipment for its first project. The project will have a life of five years. At the end of five years, the equipment will be worthless. The founders of the company told the loan officer that they would be willing to pay a much higher interest rate on a simple interest loan rather than contracting to an add-on interest loan. O The loan officer should offer the company a simple interest loan. The bank will make more money in the long run, because it can charge a much higher interest rate. O The loan officer should offer the company an add-on interest loan because there is a high risk that the company wll not be able to repay the principal on the loan at the end of the project's life.Explanation / Answer
Simple interest monthly payment = Principal x Interest rate x Period / No. of months = 450,000 x 9% / 12 = $3,375
Add-on interest monthly payment = Principal x (1 + interest rate x period) / No. of months = 450,000 x (1 + 6%) / 12 = 39,750
As the startup financing is a high risk activity, the loan officer should offer add-on interest loan because of the probability that the firm may not be able to repay the principal at the end of the tenure.
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