Question

Biochemical Corp. requires $550,000 in financing over the next three years. The firm can borrow the funds for three years at 10.60 percent interest per year. The CEO decides to do a forecast and predicts that if she utilizes short-term financing instead, she will pay 8.75 percent interest in the first year, 13.25 percent interest in the second year, and 10.15 percent interest in the third year. Determine the total interest cost under each plan. Which plan is less costly?

Short answer

The fixed-cost financing plan is a less costly financing option for the company.

Step-by-step solution

Information given in the question

The following information is provided:

Financing required in next three years = $550,000

Cost of financing = 10.60% per annum

The interest rate on short-term financing inthefirst year = 8.75% per annum

The interest rate on short-term financing inthesecond year = 13.25% per annum

The interest rate on short-term financing in the third year = 10.15% per annum

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

The cost of financing is $174,900.$$\begin{gathered} Costoffinancing=Borrowedfunds\times Interestrate\times Time \\ =\$550,000\times \$10.60\%p.a.\times 3 \\ =\$174,900 \end{gathered}$$

Cost of financing using short-term financing

The cost of financing is $176,825.

$$\begin{gathered} Costoffinancing=Borrowedfunds\times Interestrate\times Time \\ =\left(\$550,000\times \$8.75\%p.a.\times 1\right)+ \\ \left(\$550,000\times \$13.25\%p.a.\times 1\right)+ \\ \left(\$550,000\times \$10.15\%p.a.\times 1\right) \\ =\$48,125+\$72,875+\$55,825 \\ =\$176,825 \end{gathered}$$