Short-term versus longer-term borrowing Biochemical Corp. requires $500,000 in f

Question

Short-term versus longer-term borrowing Biochemical Corp. requires $500,000 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 7.25 percent interest in the first year, 11.90 percent interest in the second year, and 8.15 percent interest in the third year. Determine the total interest cost under each plan. Which plan is less costly?

Explanation / Answer

At 10.6% interest rate Final value of borrowed amount = $500,000*(1+10.6%)^3 = $676,449.51 Interest paid = $676,449.51 - $500,000 =176,449.51 Short term financing Final value of borrowed amount = $500,000*(1+7.25%)*(1+11.90%)*(1+8.15%) = $648,968.95 Interest paid = $648,968.95 - $500,000 = $148,968.95 Short term financing plan is less costly

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