Question

On January 1, 2018, Red, Inc. borrowed cash by issuing a $500,000, 5-year note that specified 6% interest to be paid on December 31 of each year and the $500,000 to be paid at maturity. If the note had instead been an installment note to be paid in four equal payments at the end of each year beginning December 31, 2018, which of the following would be true?

		The annual cash payment would have been less.
		The first year's interest expense would have been higher.
		The second year's interest expense would have been less.
		The effective interest rate would have been higher.

Answer 1

• Red Inc if paid interest on Note annually @6%, the interest expense each year will be $30000
• However, if note had been instalment note, Red Inc would be paying Intetest plus principal payment each year.
• Options and which of the is true---
• ‘a’ The annual cash payment would have been less: FALSE, because, the amount paid under instalment note would include interest payment + principal repayment which would have been more than $30000 of interest expense.
• ‘b’ the first year’s interest expense would have been higher: FALSE. Because under both the methods, the amount outstanding at the beginning for interest calculation would be $500000 and interest at 6% would have been same for fist year.
• ‘c’ the second year’s interest expense would have been less: TRUE, because, after first instalment had been paid, the note payable’s balance outstanding would have been reduced from $500000, and hence interest in second year would have been lower than $30000
• ‘d’ the effective interest rate would have been higher: FALSE, it would have been lower.