Question

Biochemical Corp. requires $690,000 in financing over the next three years. The firm can borrow the funds for three years at 9.25 percent interest per year. The CEO decides to do a forecast and predicts that if she utilizes short-term financing instead, she will pay 7.50 percent interest in the first year, 12.15 percent interest in the second year, and 8.25 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.
Interest Cost
Long-term fixed-rate $
Short-term variable-rate $
b. Which plan is less costly?
Short-term variable-rate plan
Long-term fixed-rate plan

Answer 1

Answer:

a. We have:

Interest cost of long-term fixed-rate = $191,475

Interest cost of short-term variable-rate = $192,51

b. Long-term fixed rate plan is less costly

Explanation:

a. Determine the total interest cost under each plan.

Interest cost of long-term fixed-rate = Amount required to be borrowed * Fixed interest rate per year * Number of years = $690,000 * 9.25% * 3 = $191,475

Interest cost of short-term variable-rate = (Amount required to be borrowed * First year interest rate) + (Amount required to be borrowed * Second year interest rate) + (Amount required to be borrowed * Third year interest rate) = ($690,000 * 7.50%) + ($690,000 * 12.15%) + (($690,000 * 8.25%) = $192,510

b. Which plan is less costly?

Since the $191,475 interest cost of long-term fixed-rate is less than $192,510 interest cost of short-term variable-rate, this implies that long-term fixed rate plan is less costly.