You are offered two options for repaying a loan of $100 000 over the term of 20
ID: 2587653 • Letter: Y
Question
You are offered two options for repaying a loan of $100 000 over the term of 20 years:
a) You make 20 interest payments at the annual effective rate 12% , and then repay the principal by a lump-sum payment at the end of the term. The lump sum is to be accumulated by means of 20 deposits into a sinking fund, earning 25% annually. Sinking fund deposits are made at the end of each year.
b) You repay the loan by 20 equal payments at the end of each year, with the effective annual rate of interest 11%
Which option is better?
Explanation / Answer
Under option A annual expense will be
Interest = 100000 x 12% = $12000
Sinking fund = $291.59
Total Annual expense = $12,291.59
Using Financial Calculator, Set
[ N = 20, I/Y = 25%, FV = 100000, Press CPT+PMT, result would be $291.59]
Under option B annual expense will be
Annual installment = $12,557.56
Using Financial Calculator, Set
[ N = 20, I/Y = 11%, PV = -100000, Press CPT+PMT, result would be $12,557.56]
Conclusion: since annual expense under option A is lower , it is better.
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