Pure Discount Loans

• Treasury bills (T-bill) are excellent examples of pure

discount loans.
– Principal amount is repaid at some future date –
No periodic interest payments
• If a T-bill promises to repay RM10,000 in 12 months
and the market interest rate is 7 percent, how much
will the bill sell for in the market?
PV = 10,000 / (1.07)1 = RM9,345.79

Prepared by Lim Su Yin 2014 5-1

 Interest-Only Loans
• Borrower to pay interest each period and to repay the
entire principal at some future date.
• This cash flow stream is similar to the cash flows on
corporate bonds (Chapter 6).
• Consider a 5-year, interest only loan with a 7% interest,
paid annually. The principal amount is RM10,000. What
would the stream of cash flows be?

Year 1-4: Interest payments of RM10,000 x 7% = RM700

Year 5: Interest + Principal = 700 + 10,000 = RM10,700
 Prepared by Lim Su Yin 2014 5-2

Amortized Loans
• With pure discount or interest-only loan, the
principal is repaid all at once.
• With amortized loans, parts of the loan amount
(principal) is repaid over time.
• The process of paying off a loan by making regular
principal reduction is called amortizing the loan.
 Prepared by Lim Su Yin 2014 5-3

Amortized Loan with Fixed Payment

Example 1
• Each payment covers interest expense & reduces principal. •
Suppose a business takes out a RM5,000, 5-year loan at 9%. The
loan agreement calls for the borrower to pay interest on the loan
balance each year and to reduce the loan balance each year by
RM1,000.

Beginning Total Interest Principal Ending Year Balance Payment Paid Paid
Balance 1 RM 5,000.00 RM 1,450.00 RM 450.00 RM 1,000.00 RM 4,000.00 2
RM 4,000.00 RM 1,360.00 RM 360.00 RM 1,000.00 RM 3,000.00 3 RM 3,000.00
 RM 1,270.00 RM 270.00 RM 1,000.00 RM 2,000.00 4 RM 2,000.00 RM 1,180.00
RM 180.00 RM 1,000.00 RM 1,000.00 5 RM 1,000.00 RM 1,090.00 RM 90.00
RM 1,000.00 RM - Totals RM 6,350.00 RM 1,350.00 RM 5,000.00

Prepared by Lim Su Yin 2014 5-4

Amortized Loan with Fixed

Payment Example 2

The most common way of amortizing a loan is to have the

borrower make a single, fixed payment every period.
RM5,000 = C x [(1 - 1/1.095)]/0.09 = RM1,285.46

Beginning Total Interest Principal Ending Year Balance Payment Paid Paid
Balance 1 RM 5,000.00 RM 1,285.46 RM 450.00 RM 835.46 RM 4,164.54 2 RM
4,164.54 RM 1,285.46 RM 374.81 RM 910.65 RM 3,253.88 3 RM 3,253.88 RM
1,285.46 RM 292.85 RM 992.61 RM 2,261.27 4 RM 2,261.27 RM 1,285.46 RM 203.51
RM 1,081.95 RM 1,179.32 5 RM 1,179.32 RM 1,285.46 RM 106.14 RM 1,179.32 RM -
Totals RM 6,427.30 RM 1,427.31 RM 5,000.00
 Interest Paid = Beginning Balance * Rate (9%)
Principal Paid = Total Payment – Interest Paid
Ending Balance = Beginning Balance – Principal Paid
Prepared by Lim Su Yin 2014 5-5

Reference
Ross, Westerfield and Jordan (2011). Corporate
Finance Essentials, 7th Ed., McGraw-Hill Global
Edition.
Prepared by Lim Su Yin 2014 5-6