Question

Boatler Used Cadillac Co. requires $850,000 in financing over the next two years. The firm can borrow the funds for two years at 12 percent interest per year. Mr. Boatler decides to do forecasting and predicts that if he utilizes short term financing instead, he will pay 7.75 percent interest in the first year and 13.55 percent interest in the second year. Determine the total two-year interest cost under each plan. Which plan is less costly?

Short answer

The short-term financing plan, $181,050, isaless costly financing option for the company as the other option has the total cost of financing at $204,000.

Step-by-step solution

Information given in the question

The following information is provided:

Financing required in next two years = $850,000

Cost of financing = 12% per annum

The interest rate on short-term financing inthefirst year = 7.75% per annum

The interest rate on short-term financing inthesecond year = 13.55% per annum

Cost of financing at 12% p.a. interest rate

The cost of financing is $204,000

$$\begin{gathered} Costoffinancing=Borrowedfunds\times Interestrate\times Time \\ =\$850,000\times \$12\%p.a.\times 2 \\ =\$204,000 \end{gathered}$$

Cost of financing using short-term financing

The cost of financing is $181,050.

$$\begin{gathered} Costoffinancing=Borrowedfunds\times Interestrate\times Time \\ =\left(\$850,000\times \$7.75\%p.a.\times 1\right)+\left(\$850,000\times \$13.55\%p.a.\times 1\right) \\ =\$65,875+\$115,175 \\ =\$181,050 \end{gathered}$$