Question

P10-3 Cayman Diving, Inc., needs to acquire a newdive boat. The seller will accept a noninterest-bearing note for $400,000 due in four years or $250,000 in cash. The company’sincremental cost of borrowing is 10%.Required:Which option should Cayman Diving select? Would your answer change if Cayman’s incre-mental borrowingrate was 13%? Why?

Consider P10-3 Determining Asset Cost when purchasing with a note on page 586. Which option should Cayman Diving select? Would your answer change if Cayman’s incremental borrowing rate was 13%? Why?

Answer 1

Solution:

Cash price of Boat = $250,000

IF Boat is acquired through non interest bearing note then payable amount after 4 years = $400,000

Incremental cost of borrowing = 10%

Present value of note = $400,000 * PV factor at 10% for 4th period

= $400,000 * 0.683013 = $273,205

As cash price is lower than present value of note, therefore Caymon Diving should select cash purchase option.

If incremental borrowing rate was 13% then present value of note = $400,000 * PV factor at 13% for 4th period

= $400,000 * 0.613319 = $245,328

If incremental borrowing rate is 13% then present value of note is lower than cash purchase price, therefore Boat should be purchased by issuing note.

Assets cost when purchasing with note = $273,205