workers are required to meet production needs? Is the business growing, and how does it compare to competition?
In today’s marketplace, economic downturns force business managers to face new challenges. This book will minimize the effects of these potentially disastrous periods. It is designed to maximize both the profits and the value of the firm for its owners. This is a central objective of this book, and each financial procedure discussed is linked to the impact it has on the value of the firm. The reader will find this book useful, practical, comprehensive, and profitable. Keep it handy as an easy-to-use reference. There is cross-referencing of topics and mathematical techniques. The index can be used to find a specific area of interest. The glossary defines important mathematical terms.
In summation, this book is an invaluable addition to any library and will provide quick and accurate answers to the business entrepreneur and manager. It will make an individual “savvy,” comfortable, and proficient in both the business math and the financial applications required for the successful operation of any business.
Jae K Shim
Los Alamitos, California
I wish to express my deep gratitude to Mike Jeffers of Glenlake for this edition. The input and efforts are much recognized and appreciated. Many thanks also go to Lana Murillo and Christina Ramos of California State University, Long Beach for their excellent editorial contribution in the production stage.
Evaluating the Cost of Bank Loans, Business Loans, Trade Credit, and Other Financing
1. Understanding Simple Interest
Introduction
The fee charged for the use of money, or principal, is called interest. It is the amount charged by a lender to a borrower. The interest rate is usually stated on an annual basis. The sum of the principal and the interest due is called the accumulated value, amount due, or maturity value. Compound interest is discussed in Sec. 60, How Do You Calculate Future Values? How Money Grows?
How is it Computed?
The amount of interest due is based on three factors: the principal, the rate of interest, and the time period during which the principal is used. One year is generally used as the time period. Simple interest is calculated on original principal only. The formula for simple interest is:
Interest = principal × rate × time
I = Prt
The maturity value S is given as:
Maturity value = principal + interest
Although the time span of a loan may be given in days, months, or years, the rate of interest is an annual rate. Thus, when the duration of a loan is given in months or days, the time must be converted to years. When the time is given in months, the formula is:
Example 1
A business owner obtains a 2-year loan of $10,000 from the Amalgamated Bank. The bank charges an annual simple interest rate of 10 percent. The rate of interest charged for 1 year is $1,000, calculated as follows:
$10,000 × 10% × 1 year = $1,000
The total simple interest for the 2-year period is $2,000, calculated as follows:
$1,000 × 2 years = $2,000
The maturity value (S) of the loan is $12,000, calculated as follows:
I = Prt
S = P + 1 = $10,000 + $2,000 = $12,000
Example 2
A business owner obtains a 3-month loan of $10,000 from Fidelity Bank. The bank charges an annual simple interest rate of 10 percent. The interest charged for the 3-month period is $250, and the maturity value of the loan is $10,250, calculated as follows:
P = $10,000r = 10% or 0.10t = 3/12 month
I=Prt
$10,000 × 0.10 × 3/12 month = $250
The maturity value of the loan is
S = P + I
$10,000 + $250 = $10,250
How is it used and applied?
The owner must know how to determine the cost of money in a debt or lease agreement. By knowing the cost of borrowing, the owner can better plan a business strategy to obtain an adequate return on his or her money and to provide sufficient funds to pay principal and interest.
The business owner who seeks a loan should shop around to obtain the best interest terms possible. Excessive interest rates, although they are tax deductible, are a drain on an owner’s profits. Large outstanding loans, coupled with high interest rates, can substantially reduce an owner’s profits and impair a business’ credit rating. A balance sheet showing high interest-bearing loans can also result in lenders charging even higher rates of interest because of the possibility of default and even bankruptcy if the loans are not paid at their maturity date.
See Sec. 2, Real (Effective) Interest Rate.
2. Real (Effective) Interest Rate
Introduction
The stated rate of interest does not tell the whole story: you need to be sure you understand all the fees and charges that might affect the real interest rate. The real rate of interest on a loan is expressed as an annual percentage applicable for the life of the loan.
How is it computed?
For a discounted loan, which is a common form of loan, interest is deducted immediately in arriving at the net proceeds - which increases the effective interest rate. A bank may require a compensating balance, i.e., a deposit that offsets the unpaid loan. In this case, no interest is earned on the compensating balance, which is stated as a percentage of the loan. A compensating balance also increases the effective interest rate.
Example
A business takes out a $10,000, 1-year, 10% discounted loan. The compensating balance is 5 percent. The effective interest rate is:
How is it used and applied?
Business owners compute the effective interest rate to determine the true cost of borrowing.
See Sec. 3, The Cost of Credit:
