Businesses often face decisions such as buying large pieces of equipment or embarking on expensive construction projects. These types of endeavours often require the company to spend significant amounts of money that the company might not have readily available. As a result, they often have to raise funds in some way. This may involve activities such as selling capital assets, issuing shares or, perhaps most commonly, borrowing from sources such as financial institutions or private investors. In this chapter, we are going to focus on the latter. Such borrowing arrangements are generally referred to as loans, as the lender loans money to the borrower.
In everyday life, perhaps most frequently encountered forms of borrowing include car loans, credit cards and house mortgages. These involve spending a money you don’t have to obtain a product now and eventually repaying the borrowed money plus interest. Typically, repayment is accomplished through periodic payments, e.g. monthly, or as a lump sum payment. These concepts apply not only to personal spending but also to business expenditures. In all cases, borrowing money is not a decision to be taken lightly. One must understand the advantages and disadvantages of borrowing money and the consequences of debt.
So, what are the benefits and implications of borrowing money? The benefit to an individual or a company is that they can undertake projects or purchases without having to save all of the money in advance. For an individual, this might mean they can buy a car now rather than saving for several years before buying it. For businesses, this can have even more significant implications: it can allow them to buy equipment to increase production and, therefore, allow it to increase revenues. In other sectors, this may enable them to undertake capital projects such as new bridges, buildings, factories or plants, which may generate revenues for many years to come. As we have seen in Chapter 3, a dollar today is worth more than a dollar tomorrow, so companies want to start generating revenues today.
However, one must also realize that there are consequences to spending money before you actually have it. That is, there are costs associated with borrowing money. The most apparent cost is the interest charged on the amount borrowed. Paying interest essentially increases the cost of the equipment or project. Also, you run the risk of not being able to repay the loan, in which case the lender might repossess the company’s assets or may just lose money. Thus, debt exposes both the borrower and the lender to more risk. Therefore, the more debt a company has, the less they’re able to borrow until some of it is paid off.
The goal of this chapter is to introduce and discuss some of the debt and financing concepts commonly dealt with by individuals and businesses. This chapter will delve further into interest and compounding concepts covered in chapter 3, and enable students to analyze more complex situations.
- Benefits and costs of borrowing
- Loans, mortgages, and leases
- Compounding frequency and payment frequency
- Nominal vs. effective annual interest
- Loan payments
- Annuities and perpetuities
After completing this chapter, students should be able to:
- Explain motivations for, and implications of, borrowing
- Compare financing options such as leases, loans, and cash purchases
- Calculate effective interest rates based on the nominal interest rate, payment frequency, and compounding frequency
- Calculate payment amounts, interest paid, and remaining balances for loans and mortgages
- Develop amortization schedules
- Evaluate annuities and perpetuities