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the question explains about the default in loan . I wanted to understand how should i distinguish between burrower and lender in question.
distinction between interest rate, discount rate , effective rate of interest being used in scenarios like grainger.I don’t have the question to hand so I’m flying blind when I answer you!
I can’t imagine a question that doesn’t clearly indicate the borrower (burrower?) and the lender. I suggest that you read the question again and clear up that issue for yourself. If you still can’t draw that distinction, post again with the salient extracts from the question and I’ll try to explain
Interest rate is the coupon rate or the rate identified on a loan / financial instrument / lease and is the basis for the calculation of the financing of those instruments. So a 5% interest rate on a $100,000 loan means the borrower will PAY $5,000 loan interest each year
Effective rate is where the REAL cost of, say, borrowing is greater because the loan may be redeemable at a premium. That premium needs to be spread over the term period of the loan between the date of borrowing and the repayment date.
Say the 5% loan above had an effective rate of 7%. The REAL cost of borrowing that $100,000 should be $7,000, but only $5,000 has actually been paid. We therefore need to provide for the difference between effective interest and paid interest – in the above example, that’s $2,000
The double entry is Dr Finance Costs and Cr the Loan account with 2,000
Discount rate is the company’s cost of capital. A $100,000 loan repayable in three years time has a present value. That is, we need to bring that $100,000 obligation back to today and state it at its discounted value.
We do this by multiplying the $100,000 by the cumulative discount factor for three years and, in the case of a 10% cost of capital / discount rate, that’s pretty close to .751. That value is itself determined by calculating how much we would need to invest today at a compound rate of interest of 10% in order that we should have $100,000 in three years’ time.
$751 after one year invested at 10% will be worth $826
$826 after another year will have grown to $909 and that amount, in turn, will have grown after the third year to $100,000
That’s compound interest. Discounting attacked the problem from the obverse angle. If you multiply 100,000 by 1/1.10 three times, you arrive at the today “value” of $100,000 payable in three years and it should come to something like $75,100
Try it!
Does that help?
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