Financing Long-Term Activities and Loan Mechanics

Exam Coverage

• Only material covered in class is on the exam.

• Anything in this learning module not covered in class will not be on the exam.

Long-Term Company Financing

• Companies finance long-term activities (e.g., buying machines, buildings, launching products) through:

  • Equity: Giving an ownership interest by selling stocks (stocks have no end date and can be resold). Investors provide money for ownership.

  • Debt: Borrowing money with an agreement to repay the principal plus interest over a set period.

  • Traditional Loan: A one-on-one situation between a lender and a borrower; terms and amounts are negotiated, often involving credit risk assessment.

  • Bond: A type of loan where a company borrows money from many different investors, promising to repay with interest (will discuss after midterm).

Loan Basics (Debt)

• Principal: The initial amount of money lent.

• Interest: The fee the lender earns for providing the loan.

• Note: The legal contract documenting the loan agreement, enforceable in court.

• Collateral: An asset that the lender can seize and sell if the borrower defaults on repayment (e.g., a car for an auto loan, real estate for a mortgage). A loan with collateral is a secured loan.

Loan Repayment Types

• Pure Discount Loan:

  • The lender lends money, and the borrower promises to repay the entire principal amount plus all accrued interest at maturity (the end of the loan term).

  • Typically used for short-term loans (e.g., one year or less).

  • Example: A $100,000$ loan at $7\%$ annual interest repaid in one year would be $100,000 \times (1 + 0.07) = 107,000$ owed at maturity.

• Interest-Only Loan:

  • The borrower makes periodic interest payments throughout the loan term.

  • The full principal amount is repaid as a single lump sum at maturity.

• Amortized Loan:

  • Both interest and a portion of the principal are paid back in equal installments every period.

  • At the end of the loan term, the entire loan (principal and interest) is fully paid off, and nothing is owed.

  • Each payment is fixed, but the allocation changes over time:

  • The interest portion of each payment decreases over time.

  • The principal portion of each payment increases over time.

  • Commonly used for car loans, residential mortgages, and medium-term business loans.

Amortization Schedule & Calculations

• Amortization Schedule: A detailed table that breaks down each loan payment over the life of the loan.

  • Columns typically include: Period, Beginning Balance, Payment, Interest Paid, Principal Paid, and Ending Balance.

  • Payment: The fixed amount paid each period, calculated using financial calculator functions ($PV$, $N$, $I/Y$, solve for $PMT$, with $FV = 0$).

  • Interest Paid (for a period): Calculated as (Beginning Loan Balance) $\times$ (Periodic Interest Rate).

  • Principal Paid (for a period): (Total Payment) $-$ (Interest Paid).

  • Ending Balance (for a period): (Beginning Loan Balance) $-$ (Principal Paid).

• Finding Remaining Loan Balance:

  • Can be determined directly from the amortization schedule (the ending balance of the last completed period).

  • Can also be calculated using a financial calculator by finding the present value ($PV$) of the remaining payments.

  • Use total number of remaining payments for $N$. For example, after $60$ months of a $360$-month loan, $N = 300$. Use the original periodic interest rate ($I/Y$) and the fixed payment ($PMT$).

• Sign Convention in Calculator: Essential for accurate calculations.

  • Money received (e.g., the initial loan amount as $PV$ for the borrower) is typically entered as a positive number.

  • Money paid out (e.g., periodic payments as $PMT$ for the borrower) is typically entered as a negative number.