Rentals, Inc., needed to borrow some money, and he needed it fast. He was a pioneer in the business of buying older cars and renting them to students visiting companies for experiential learning! Rapid expansion of his rental locations was necessary to discourage competitors from entering the business. He hoped to open two new offices . To do this, Rentals would need about $2.5 million for location development and purchase of a fleet of well-used automobiles.

Saeed's personal assistant, Ms. Bushra Naqvi, told him that he could get the money Rentals needed from Practically-Free-Loans, Inc. (PFLI), a local loan broker. She suggested Rentals offer PFLI three annual payments of Rs. 1 million each, the first to be due one year from the date of the loan, and the second and third at subsequent one-year intervals. Naqvi said that Rentals would receive a loan of about $ 2,486,900 if PFLI would be satisfied with an interest rate of 10%. She also explained that during the first year, interest expense on the loan would total $ 248,690, and when the first $1 million payment was made, the principal owed to PFLI would be reduced by the difference between the $ 1 million paid and the interest expense.

Questions

1. How did Ms. Naqvi know that Rentals would get nearly Rs. 2.5 million if PFLI would lend at a 10% interest rate?

2. Assume Ms. Naqvi is right, and PFLI is willing to lend on Mr. Saeed's promises to pay $1 million each year for three years. How much will Rentals owe on the day the loan is taken? How much will it owe one year later just before the first payment of $ 1 million is made to PFLI? What will be the liability of Rentals just after the first $ 1 million payment is made to PFLI?

3. Calculate the interest expense for Rentals for the second year of the loan and the liability at the end of that year after the annual $ 1 million payment is made?

Ms. Naqvi had suggested to Kamran Saeed that there was an alternative to dealing with the local Loan Sharks. She thought LUMS Rentals could float a bond issue. She suggested selling 2,500 bonds with a face value of Rs. 1,000 each and a coupon interest rate of 10% to be paid annually. The principal amount of the bonds, Rs. 2.5 million, would be due and paid at the end of the third year.

4. If Rentals decides to issue the bonds suggested by Ms. Naqvi, and investors wish to earn exactly 11% interest on their investment, how much will Rentals get from selling the bonds? On the day the bonds are issued, is that the total amount of LUMS Rental’s liability?

5. What will Rental’s total liability be at the end of the first year just before the interest payment is made? Just after? At the end of the second year? The third year?

6. What will be the proceeds of the 10% bond issue if investors are content to earn an 8% interest rate?