FIN.10:5.1 - The same rate can provide different payment capacity

A separate corporation must pay 100 for an investment now and retain its existing cash reserve of 10. Two actually offered loans each deliver 100 net now, with no fees, tax differences or other restrictions. Both charge 10% annually on outstanding principal. Loan A repays 50 of principal at each year end; its payments are 60 in year 1 and 55 in year 2. Loan B pays interest 10 in year 1 and principal plus interest 110 in year 2. The investment and the rest of the business together provide cash of 28 and 115 at those year ends after every nonfinancing requirement. No additional source is available and no earlier shortfall occurs.

Loan A would leave 10 + 28 − 60 = −22 in year 1. Its nominal interest total of 15 does not make it usable. Loan B leaves 28 after year 1 and 33 after year 2, so it preserves the reserve at both dates. At a 10% comparison rate, each payment schedule has present value 100: 60/1.10 + 55/1.10² equals 10/1.10 + 110/1.10². The difference is the timing of principal use, not a lower effective rate.

If operating receipts move so that available cash becomes 60 in year 1 and 83 in year 2, preserving the total 143, Loan A leaves 10 and then 38. Both schedules now fit. Comparing their remaining cash requires the use and return of any interim surplus; comparing the final balances alone ignores that Loan B leaves more cash available after year 1. A decision to prefer one must therefore state that use or the relevant flexibility, not merely count interest.