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Qns (c) As an alternative to paying the principal on the loan as one lump sum at the end of the fourth year, CMC Co could pay off the loan in equal annual amounts over the four years similar to an annuity. In this case, an annual interest rate of 2% would be payable, which is the same as the loan’s gross redemption yield (yield to maturity).
Loan is CHF60,000,000
How come we cannot CHF60,000,000/4 yrs ? But how come we need to divide based on CHF60,000,000/discount factor annuity factor (3.808) of ( DF 2%, 4 yrs) instead?
Will appreciate if you can enlighten me on it.
Thanks!
Joanna.If they were to pay off the loan over four years, then there would be interest payable on the amounts left outstanding at the end of each year.
If they are making equal payments each year then the payments have to cover the interest as well as the loan itself.
The present value of the repayments must equal the amount of the loan, which is why we divide by the annuity discount factor.
(My free Paper F2 lectures may help you with this, because this is revision of F2 and F9).
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