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Homework answers / question archive / Problem 6-7 Short-term versus longer-term borrowing (L06-3] Boatler Used Cadillac Co
Problem 6-7 Short-term versus longer-term borrowing (L06-3] Boatler Used Cadillac Co. requires $940,000 in financing over the next two years. The firm can borrow the funds for two years at 11 percent interest per year. Ms. Boatler decides to do forecasting and predicts that if she utilizes short-term financing instead, she will pay 7.25 percent interest in the first year and 12.55 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. Interest Cost Long-term fixed-rate Short-term variable-rate b. Which plan is less costly? Short-term variable-rate plan Long-term fixed-rate plan
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Answer:
a)
Interest cost under long term fixed rate
Long term fixed rate is 11%
Interest cost for 2 years = $940000 * 11% * 2 years
= $206800
Interest cost under long term fixed rate is $206800
Interest cost under short term variable rate
First year interest rate is 7.25%
Second year interest year is 12.55%
Interest for First year = $940000 * 7.25%
= $68150
interest for second year = $940000 * 12.55%
= $117970
Total interest cost = $68150 + $117970
= $186120
Interest cost under short-term variable-rate is $186120
b)
Interest cost under long term fixed rate is $206800
Interest cost under short-term variable-rate is $186120
The interest cost under short-term variable- rate is less than the interest cost under long term
fixed-rate
Therefore, short-term variable-rate plan is cheaper
