1. A bank currently with a 4-year $10 million non-amortizing loan paying 7% inte

Question

1. A bank currently with a 4-year $10 million non-amortizing loan paying 7% interest rate is in negotiations to reschedule its payment terms. The new terms will extend the loan to eat years and require interest payments of 2% for the first four years and 8% for the last four years. The full principal of $10 million will be paid at the end of year 8. An upfront fee of 1% will be charged in year 0. If we assume the cost of funds for the banks is 3% before rescheduling and 4% after rescheduling, is the bank better off with the new terms? Explain and show work.

2. Continuing with problem 1, what should the cost of funds after rescheduling for the present value of the new loan to be the same as the present value of the old loan?

Explanation / Answer

1). As the loan is non-amortizing, hence the interest would be paid over the period of years for both the cases of before rescheduling of debt and after that. And loan principle amount would be paid at the end of the term in both cases.

Now for case-I i.e before rescheduling - the interest payments would be $ 0.7 mn for 4 years and principle would be repaid at the end of 4th year. So we should find the PV of these interest payments and also we should find the PV of loan amount to compare and see the value of loan that bank would get back after 4 years and after 8 years, which is better.

So for Case-1 the PV of interest payments = $2.602 mn, but the overall PV of loan with interest = $ 11.487 mn.

Similarly for Case-2 interest for first 4 years = $0.2mn each and $0.8mn each for next 4 years. So the PV of interest payments for this = $ 3.209 mn but the overall value of loan with interest = $ 10.616 mn (including upfront fees).

So we can see the PV of Case-1 is higher so it wont be beneficial for bank to do the rescheduling from the overall loans perspective but from the interest payments perspective it would be beneficial.

2). For the PV of new loan to be same as that of the old one. We have to equate the PV of both and from this iterative approach we get that the cost of funding would be approx 2.7425%.

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