Let Suppose

Jan 1, 2020 Loan obtained from HBL = $6,000

Interest rate = 10% per annum

Loan is payable in 4 equal-annual-end-of-year instalments = $1893

Required: prepare a loan amortization schedule and prepare necessary journal entries to record the
amount of loan.

1893 X 4 = 7572- 6000 = 1572

(1)Instalment (2) Principal at the start Instalment (5) Principal at the

end (2-4)
(3) (4)
Interest Principal
Col 2 X (1-3)
10%
1893 6000 600 1293 4707
1893 4707 471 1422 3285
1893 3285 329 1564 1721
1893 1721 172 1721
Total 1572 6000

Date Description Post Debit Credit

Ref
1 Jan Cash 6000
2020 Loan payable 6000
31 Dec Interest expense 600
2020 Loan payable 1293
Cash 1893

31 Dec Interest expense 471

2021 Loan payable 1422
Cash 1893

31 Dec Interest expense 329

2022 Loan payable 1564
Cash 1893

31 Dec Interest expense 172

2023 Loan payable 1721
Cash 1893
As per explanation given in accounting text books the basic advantage of using the debt is tax
concession

For instance

Company A = using some combination of debt and equity to finance its assets i.e. Assets = Debt + Equity
When a company using fixed cost funds like debt then interest payment is fixed as well as mandatory
thus this company called financially levered firm.

Company B = using only equity to finance its assets i.e. Assets = Equity (So do not believe on fixed cost
funds called financially unlevered firm)

Company Company Difference

A B
(Levered) (Unlevered)
Sales 1,000,000 1,000,000
Cost of goods sold 300,000 300,000
Gross profit 700,000 700,000
Less operating expenses 200,000 200,000
Earnings before interest and 500,000 500,000
taxes
Less Interest expense 200,000 0
Earnings before taxes 300,000 500,000
Less: Taxes @40% 120,000 200,000 80,000*
Profit after taxes 180,000 300,000
*levered company is paying 80,000 less tax than tax paid by unlevered firm. This is called as tax
advantage of using debt.

Moreover, saving in tax lead to reduction in effective cost of debt. For example, if the amount of loan is
2,000,000 and the cost of loan is 10% per annum

Interest = Principal X Rate X Time = 2,0000,000 X 10/ 100 = 200,000

Effective cost of loan = Interest paid – Taxes saved / Principal = (200,000 – 80,000)/ 2000,000 = 0.06 x
100= 6%

So the actual cost bear by the firm is less due to tax-shield benefit on interest payment. So if the amount
of interest is 200,000 the tax saving is 200,000 x 40/100 = 80,000