Case 2: Calculating Effective Annual Rates of Interest in Malaysia

Background:
You are a financial analyst working for a prominent bank in Malaysia. A client is
considering two financing options for a significant investment and has approached you
to calculate the Effective Annual Rate (EAR) of interest for both options.
Case Details:
Financing Option 1: Bank Loan
Your client is considering a bank loan to finance the purchase of a new factory for their
business. The loan amount is RM1,000,000, and the bank offers an interest rate of 5%
per annum, compounded semi-annually. The loan term is 5 years.
Financing Option 2: Corporate Bond
The client is also exploring the option of purchasing a corporate bond from a reputable
Malaysian company. The bond has a face value of RM1,000,000 and a coupon rate of 4%
per annum. It matures in 4 years.

Questions:
1. Calculate the future value of the bank loan after 5 years.
Show your step-by-step calculations.
2. Calculate the future value of the corporate bond after 4 years.
Walk through the calculations.
3. Calculate the EAR (Effective Annual Rate) for the bank loan.
Use the future value from question 1 to calculate the EAR.
4. Determine the EAR for the corporate bond.
Utilize the future value from question 2 to find the EAR.
5. Advise the client on the more cost-effective financing option based on the
calculated EAR for both options.
6. Provide a recommendation considering the interest rates and maturities.
Question 1: Calculate the future value of the bank loan after 5 years.
Answer:
To calculate the future value of the bank loan, we can use the formula for future
value with compounding:
Future Value = Principal * (1 + (Annual Interest Rate / Compounding Periods)) ^
(Compounding Periods * Number of Years)
In this case, the principal is RM1,000,000, the annual interest rate is 5%, and the
interest is compounded semi-annually (2 times per year) for 5 years:
Future Value = RM1,000,000 * (1 + (0.05 / 2))^ (2 * 5)
Future Value = RM1,000,000 * (1 + 0.025)^10
Future Value = RM1,000,000 * (1.025)^10
Future Value ≈ RM1,283,355.05

Question 2: Calculate the future value of the corporate bond after 4 years.
Answer:
The future value of the corporate bond is the sum of the face value and the interest
earned. The bond has a face value of RM1,000,000 and a coupon rate of 4% per
annum. It matures in 4 years, so we can calculate the interest earned as follows:
Interest Earned = Face Value * Coupon Rate * Number of Years
Interest Earned = RM1,000,000 * 0.04 * 4
Interest Earned = RM160,000
Now, add the interest earned to the face value to calculate the future value:
Future Value = Face Value + Interest Earned
Future Value = RM1,000,000 + RM160,000
Future Value = RM1,160,000

Question 3: Calculate the EAR (Effective Annual Rate) for the bank loan.
Answer:
To calculate the EAR for the bank loan, we can use the formula:
EAR = [(1 + (Annual Interest Rate / Compounding Periods))^Compounding Periods -
1]
In this case, the annual interest rate is 5%, and the interest is compounded semi-
annually (2 times per year):
EAR = [(1 + (0.05 / 2))^2 - 1]
EAR = (1 + 0.025)^2 - 1
EAR = (1.025)^2 - 1
EAR ≈ 0.050625 or 5.06%

Question 4: Determine the EAR for the corporate bond.

Answer:
The EAR for the corporate bond is equal to the nominal coupon rate of 4% because
there is no compounding involved in the bond's interest payments. Therefore, the
EAR for the corporate bond is 4%.

Question 5: Advise the client on the more cost-effective financing option based
on the calculated EAR for both options.
Answer:
Based on the calculations:
The bank loan has an EAR of approximately 5.06%.
The corporate bond has a fixed nominal coupon rate of 4%, which is also the EAR.
Considering the calculated EARs and assuming all other factors are equal, the
corporate bond appears to be the more cost-effective financing option for the
client. It offers a fixed interest rate of 4%, which is lower than the bank loan's
effective annual rate of approximately 5.06%. However, other factors such as
risk, liquidity, and terms and conditions should also be considered before
making a final recommendation.