Question

Boats R Us requires $800,000 in financing over the next 2 years. The firm can borrow the funds for 2 years at 12% interest per year. The owner, Boaty McBoaterson, decides to do forecasting and predicts that if he utilizes short term financing instead, he will pay 7.00% interest the first year, and 13.95% interest the second year. Determine the total 2-year interest cost under each plan. Which plan is less costly?

Answer 1

Boats R has two options

Option 1 : $800000 at 12% Per year

we will calculate the interest that Boat R has to pay over 2 year

Amount = Principal * (1 + Interest Rate for 1st Year) * (1 + Interest Rate for 2nd Year)

Amount = 8,00,000* ( 1+12%)*( 1+12%)

= 800000 *1.2544

= 1003520

Interest Paid= Amount - Principal

= 1003520 - 8,00,000

Interest Paid = $203520

Option 2: Short Term Financing

we will calculate the interest that Boat R has to pay over 2 year

Amount = Principal * (1 + Interest Rate for 1st Year) * (1 + Interest Rate for 2nd Year)

= 8,00,000 * (1 + 7%) * (1+ 13.95%)

= 800000 *1.07 * 1.1395

= $975412

Interest Paid = Amount - Principal

= 975412 - 800000

Interest Paid = 175412

the interest paid in 2nd option that is short term financing is less than option 1 that is 12% for both years , Therefore, option 2 short term financing should be choosen.