Question: Question 3

Garisco Inc. is negotiating a balloon payment loan of $300,000 to be repaid in a lump sum at the end of nine years. Interest payments will be made on the loan at the end of each year. The company is considering three arrangements:

1) The company can borrow the money using a fixed rate loan (FRL) that requires interest payments of 9% per year.

2) The company can borrow the money using an adjustable rate loan (ARL) that requires payments of 6% at the end of each of the first five years. At the beginning of the sixth year, the interest rate on the loan could change to 7%, 9% or 11% with probabilities 0.1, 0.25 and 0.65 respectively.

3) The company can borrow the money using an ARL that requires interest payments of 4% at the end of the first three years. At the beginning of the fourth year, the interest rate could change to 6%, 8% or 10% with probabilities 0.05, 0.30 and 0.65 respectively. At the beginning of the seventh year, the interest rate could decrease by 1% with probability 0.1, increase by 1% with probability 0.2 or increase by 3% with probability 0.7.

Create a decision tree for this decision and identify the course of action that will minimize the total interest payments (ignore time value of money).

After presenting the analysis to the senior management team at Garisco, you have been told that the analysis must be done on a present value basis. The team has advised you that the appropriate annual discount rate is 15%. What course of action would you recommend now? [ This will require individual calculation of NPV for each possible cash flow. Calculation of these separately in the spreadsheet is recommended! There is an NPV function in Excel.]