Question

Build-Smart Construction Ltd wants to borrow $100,000 to finance a new $150,000 hydraulic machine to be used in a new construction project. The machine will pay for itself in one year. The firm is considering the following alternatives to buy the machine:

Option A: The firm’s bank offers to lend the $100,000 at a rate of 12% by arranging a bill for one year.

Option B: The machine dealer offers to finance the machine with a one-year loan of $100,000, and the loan would require payment of principal and interest totaling $115,500 at year-end.

(i) Determine the face value of the bill. [4 marks]

(ii) Which option should Build-Smart Construction Ltd. select? [4 marks]

(iii) What would be your answer if the bank charged a $3000 arrangement fee for the bill? [4 marks

Answer 1

i.

Face value of the bill =Amount to be borrowed/(100-discount rate)

= $ 100000/(100-12)%= 100000/88% =$ 113636.36

ii.

Outflow after one year in option A= face value of bill= $113636.36

Outflow in Option B=$ 115,500

Hence option to be selected which has a lower outflow after year one i.e . Option A

iii.

If bank charges a $ 3000 arrangement fee then amount required = $ 100000+3000=$ 103000

Face value of bill required =$ 103000/88% =$117045.45

Hence outflow in option A at year end = $ 117045.45

Outflow in option b at year end = $115500

Hence option B should be selected as it has a lower outflow.