Boatler Used Cadillac Co. requires $860,000 in financing over the next two years
ID: 2815900 • Letter: B
Question
Boatler Used Cadillac Co. requires $860,000 in financing over the next two years. The firm can borrow the funds for two years at 7 percent interest per year. Mr. Boatler decides to do forecasting and predicts that if he utilizes short-term financing instead, he will pay 5.25 percent interest in the first year and 9.55 percent interest in the second year. Assume interest is paid in full at the end of each year.
a. Determine the total two-year interest cost under each plan.
b. Which plan is less costly?
Long-term fixed-rate plan
Short-term variable-rate plan
Explanation / Answer
Solution :
a. Two year Interest cost under Long-term fixed-rate plan : = Loan amount * Interest rate * No. of years
= $ 860,000 * 7 % * 2 = $ 120,400
Two year Interest cost under Short term variable rate plan =
Year 1 = $ 860,000 * 5.25 % * 1 = $ 45,150
Year 2 = $ 860,000 * 9.55 % * 1 = $ 82,130
Thus total interest cost under Short term variable rate plan = $ 45,150 + $ 82,130 = $ 127,280
b. Since the total interest cost under the Long-term fixed-rate plan is $ 120,400 which is lesser than the interest Short-term variable-rate plan of $ 127,280, the Long term fixed rate plan is less costly.