Question

Boatler Used Cadillac Co. requires $1,010,000 in financing over the next three years. The firm can borrow the funds for three years at 7 percent interest per year. Mr. Boatler decides to do forecasting and predicts that if he utilizes short-term financing instead, he will pay 3 percent interest in the first year, 5 percent in the second year, and 11 percent interest in the third year. a. Determine the total three-year interest cost under each plan. Total Interest cost Fixed cost financing $ Variable short-term financing $ b. Which plan is less costly? Fixed cost plan Short-term plan

Answer 1

Now we have two options for financing:

1. Borrow at Fixed Cost Plan

2. Short term plan

Lets calculate the interest at Fixed Cost 7%

Here we assume that the interest is paid at the end of every year thus the total interest would be simple interest for 3 years

The formula for interest = P * R * N /100

P = 1,010,000

R = 7%

N = 3 Years

I = 1,010,000 * 7 * 3 /100

I = $2,121,000

2. Short Term Financing

Year 1

Interest for Year 1@ 3% = P * R * N /100

= 1,010,000 * 3 * 1 /100

= 303,000

Interest for Year 2 @ 5% = P * R * N /100

= 1,010,000 * 5 * 1/100

= 505,000

Interest for Year 3 @ 11% = P * R * N /100

= 1,010,000 * 11 * 1/100

= 1,110,000

Total Interest = 303,000 + 505000 + 1,110,000

= 1,919,000

Short Term Plan would be better as the interest paid would be $1,919,000 against $2,121,000 in Fixed Plan. Fixed Plan interest is higher by $ 202,000.