Question

Problem 6-8 Short-term versus longer-term borrowing [LO3] Biochemical Corp. requires $550,000 in financing over the next three years. The firm can borrow the funds for three years at 10.60 percent interest per year. The CEO decides to do a forecast and predicts that if she utilizes short-term financing instead, she will pay 8.75 percent interest in the first year, 13.25 percent interest in the second year, and 10.15 percent interest in the third year. Assume interest is paid in full at the end of each year. a.  Determine the total interest cost under each plan. b.  Which plan is less costly?
Input variables:
Required financing	$550,000
Loan term	3	years
Fixed cost interest rate	0.11
Short-term interest rate  - Year 1	0.0875
Short-term interest rate  - Year 2	0.1325
Short-term interest rate - Year 3	0.1015
Solution and Explanation:
a.
Long-term fixed-rate interest cost:
Short-term variable-rate interest cost:
Year 1 interest
Year 2 interest
Year 3 interest
Total interest
b.
Least costly plan

Answer 1

ANSWER

(a)

Total interest cost under each plan

Interest Cost under Long term fixed rate

Interest Cost = [$550,000 x 10.60%] x 3 Years

= $58,300 x 3 Years

= $174,900

“Interest Cost under Long term fixed rate = $174,900”

Interest Cost under Short term Variable Rate

Interest Cost for Year 1 = $48,125 [$550,000 x 8.75%]

Interest Cost for Year 2 = $72,875 [$550,000 x 13.25%]

Interest Cost for Year 3 = $55,825 [$550,000 x 10.15%

Total Interest Cost = $176,825 [$48,125 + 72,875 + 55,825]

“Interest Cost under Short term Variable Rate = $176825”

(b)

“Long-term fixed-rate” is less costly

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