Iris plc borrows £50m at 9.5% from Westlloyds bank for five years. What cash flows will the firm have to find if the interest and principal are paid in the following ways?a. All interest and capital is paid at the end of the period.b. Interest only is paid for each of the years (at the year ends); all principal is paid at theend.c. £10m of the capital plus annual interest is paid on each anniversary date.
The correct answer and explanation is:
Let’s analyze each scenario for Iris plc borrowing £50 million at 9.5% interest for five years. We’ll calculate the cash flows (interest and principal payments) the firm must make under the three different repayment structures:
Given:
- Principal (Loan amount) = £50 million
- Annual interest rate = 9.5%
- Loan term = 5 years
a. All interest and principal is paid at the end of the period (bullet loan)
- The firm pays no interest or principal during the 5 years.
- At the end of year 5, the firm pays all interest accumulated over 5 years + the principal.
Interest each year:
9.5% of £50m = 0.095 × £50m = £4.75 million per year.
Total interest over 5 years:
£4.75m × 5 = £23.75 million.
Cash flow at end of year 5:
Principal (£50m) + Total interest (£23.75m) = £73.75 million.
Summary:
- Years 1–4: £0
- Year 5: £73.75 million (principal + interest)
b. Interest only is paid each year; principal is paid all at the end
- Each year (years 1 to 5), the firm pays only the interest.
- At the end of year 5, the firm repays the entire principal.
Annual interest payment: £4.75 million (as above)
Year 5 principal payment: £50 million
Summary of cash flows:
| Year | Payment (£m) |
|---|---|
| 1 | 4.75 (interest only) |
| 2 | 4.75 (interest only) |
| 3 | 4.75 (interest only) |
| 4 | 4.75 (interest only) |
| 5 | 4.75 (interest) + 50 (principal) = 54.75 |
c. £10m of the principal plus annual interest is paid on each anniversary
- The firm repays £10 million of principal every year, plus the interest due on the remaining principal at the start of the year.
- This is a form of amortizing loan with equal principal repayments.
Let’s calculate the interest each year on the outstanding principal:
| Year | Principal Outstanding at start (£m) | Interest (9.5%) (£m) | Principal repaid (£m) | Total payment (£m) |
|---|---|---|---|---|
| 1 | 50 | 4.75 | 10 | 4.75 + 10 = 14.75 |
| 2 | 40 (50 – 10) | 3.8 | 10 | 3.8 + 10 = 13.8 |
| 3 | 30 (40 – 10) | 2.85 | 10 | 2.85 + 10 = 12.85 |
| 4 | 20 (30 – 10) | 1.9 | 10 | 1.9 + 10 = 11.9 |
| 5 | 10 (20 – 10) | 0.95 | 10 | 0.95 + 10 = 10.95 |
Summary and Explanation:
a) Lump sum at the end means the company avoids cash outflows until maturity but must pay a large amount at once. This can strain liquidity but delays cash outflows.
b) Interest-only payments keep the annual cash flow moderate, but the principal remains due at the end, requiring good planning for a large lump sum payment.
c) Equal principal repayments reduce the principal each year, so interest payments decline over time, reducing the firm’s annual interest expense and spreading out the cash outflows more evenly.
Why is this important?
Understanding these cash flows helps Iris plc manage liquidity and interest expenses. The loan structure impacts how much cash the firm needs each year and affects financial planning, risk, and creditworthiness. Scenario (c) is often preferred for better cash flow management, though it requires higher initial payments than scenario (b).