Mark and Todd the co-owners of CA Air Inc. were impressed by the work Chris had done on financial planning. Using Chris’s analysis, and looking at the demand for light aircraft, they have decided that their existing fabrication equipment needs replacement. Mark and Todd have identified suitable new equipment for sale, for about $20 Million. Mark, Todd and Chris are now ready to meet with AV, the Loan officer for the National Bank. The purpose of meeting is to discuss the loan options available to the company to finance the new equipment.
AV begins the meeting by discussing a 30-year loan. The loan would be repaid in equal monthly installments. Because of the previous relationship between CA and the bank there would be no closing costs for the loan. AV states that the APR of the loan would be 6.2 percent. Todd asks if a shorter loan is available. AV says that the bank does have a 20-year loan available at the same APR.
Mark decides to ask AV about a “smart loan” he discussed with a mortgage broker when he was refinancing his home loan. A smart loan works as follows: Every two weeks a payment is made that is exactly one-half of the traditional monthly loan payment. AV informs him that the bank does have smart loans. The APR of the smart loan would be the same as the APR of the traditional loan. Mark nods his head. He then states this is the best loan option available to the company since it saves interest payments.
AV agrees with Mark, but then suggests that a bullet loan or balloon payment, would result in the greatest interest savings. At Todd’s prompting she goes on to explain a bullet loan. The monthly payments of a bullet loan would be calculated using a 30-year traditional loan. In this case, there would be a 5-year bullet. This would mean that the company would make the payments for the traditional 30-year loan for the first five years, but immediately after the company makes the 60thpayment, the bullet payment, the bullet payment would be due. The bullet payment is the remaining principal of the loan. Chris then asks how the bullet payment is calculated. AV tells him that the remaining principal can be calculated using an amortization table, but it is also the present value of the remaining 25 years of payments for the 30-year loan.
Todd has also heard of an interest only loan and asks if this loan is available and what the terms would be. AV says that the bang offers an interest only loan with a term of 10-years and an APR of 3.5 percent. She goes on to further explain the terms. The company would be responsible for making interest payments each month on the amount borrowed. No principal payments are required. At the end of the 10-year term, the company would repay the $20million. However, the company can make principal payments at any time. The principal payments would work just like those on a traditional loan. Principal payments would reduce the principal of the loan and reduce the interest due on the next payment.
Mark and Todd are satisfied with AV’s answers, but are still not sure of which loan they should choose. They have asked Chris to answer the following questions to help them choose the correct financing arrangements.
- 1. What are the monthly payments for a 30-year traditional loan? What are the payments for a 20-year traditional loan? (Show calculations)
- 2. Prepare an amortization table for the first 6 months of the traditional 30-year loan. How much of the first payment goes toward principal? (Show calculations)
- 3. How long would it take for CA Air to pay off the smart loan, assuming 30-year traditional loan payments? Why is this shorter than the time needed to pay off the traditional loan? How much interest would the company save? (Show calculations)
- 4. Assume CA Air takes out a bullet loan under the terms described. What are the payments on the loan? (Show calculations)
- 5. What are the payments for the interest only loan? (Show calculations)
- 6. Which loan is the best for the company? Are there any potential risks in this action? (Show calculations)