Question

Requesting assistance with the following question please. Thank you.

Sauer Food Company has decided to buy a new computer system with an expected life of three years. The cost is $310,000. The company can borrow $310,000 for three years at 13 percent annual interest or for one year at 11 percent annual interest. Assume interest is paid in full at the end of each year.  

a. 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 11 percent rate? Compare this to the 13 percent three-year loan.
  

b. What if interest rates on the 11 percent loan go up to 16 percent in year 2 and 19 percent in year 3? What would be the total interest cost compared to the 13 percent, three-year loan?
  

Answer 1

a). If Interest rates are constant:

Interest(@13%) = $310,000 x 0.13 x 3 years = $120,900

Interest(@11%) = $310,000 x 0.11 x 3 years = $102,300

Savings(Borrowing Short-term) = $120,900 - $102,300 = $18,600

b). If short-term rate change;

1st year interest = $310,000 x 0.11 = $34,100

2nd year interest = $310,000 x 0.16 = $49,600

3rd year interest = $310,000 x 0.19 = $58,900

Total Interest borrowing short-term = $142,600

Extra Cost Borrowing Short-term = $142,600 - $120,900 = $21,700