Question

Analyze and calculate the following scenarios in 525 words, including which one would you choose and why, and which financing option is best for your busines: Investor #1 decided to loan you the $300,000, paying all of the interest (8% per year) and principal in one lump sum at the end of 5 years. Investor #2 offers you the $300,000, paying interest at the rate of 8% per year for 4 years and then a final payment of interest and principal at the end of the 5th year.

Answer 1

This question basically requires us to compare the two scenarios - one where compounding would take place and other where there would be no compounding. In both the cases, the best scenario would be where total interest paid is lower.

Scene 1:

This requires application of time value of money - compounding concept, according to which,

FV = PV * (1 + r)ⁿ

FV = $300,000 * (1 + 8%)⁵

FV = $440,798.42.

Total interest paid = $440,798.42 - $300,000 = $140,798.42

Scene 2:

Over here, all interest would be paid each year and will not accumulate - hence no compounding.

Interest (Yr 1) = $300,000 * 8% = $24,000

Every year the interest would remain same.

Hence, total interest payment in 5 years = $120,000

Since total interest payment is lower in offer from Investor 2 (Scene 2), that option should be selected.