Question

Sauer Food Company has decided to buy a new computer system with an expected life of three years. The cost is $150,000. The company can borrow $150,000 for three years at 10 percent annual interest or for one year at 8 percent annual interest. Assume interest is paid in full at the end of each year.

How much would Sauer Food Company save in interest over the three-year life of the computer system if the one-year loan is utilized and the loan is rolled over (reborrowed) each year at the same 8 percent rate? Compare this to the 10 percent three-year loan.

8 percent loan: 36000 (Correct)

10 percent loan: 45000 (correct)

Interest Savings: 9000 (correct)

b.  What if interest rates on the 8 percent loan go up to 13 percent in year 2 and 18 percent in year 3? What would be the total interest cost compared to the 10 percent, three-year loan?
Fixed-rate 10% loan:

Variable-rate loan:

Additional Interest Cost: $13,500 (correct)

Answer 1

.a One year loan at 8% rolled over:

Annual interest=0.08*150000=$12,000

Total interest paid=3*12000=$36,000

Three year 10 % interest:

Interest paid at the end of each year=0.1*150000=$15,000

Total interest paid=3*15000=$45,000

Interest saving=(45000-36000)=$9,000

.b.If the 8% interest goes up to 13% in year2 and 18% in year3:

Interest in year1=0.08*150000=$12,000

Interest in year2=0.13*150000=$19,500

Interest in year 3=0.18*150000=$27,000

Total interest cost=(12000+19500+27000)=$58,500

Fixed rate 10% loan, interest cost=$45,000

Variable rate loan, interest cost=$58,500

Additional interest cost=(58500-45000)=$13,500