Biochemical Corp. requires $680,000 in financing over the next three years. The
ID: 2615353 • Letter: B
Question
Biochemical Corp. requires $680,000 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. Assume interest is paid in full at the end of each year. a. Determine the total interest cost under each plan. b. Which plan is less costly? Long-term fixed-rate plan Short-term variable-rate plan
Explanation / Answer
We need to compute the total interest cost for each method. Since interest is paid at the end of the year, there woul dbe no compounding, and hence we use simple interest formula.
According to simple interest, Interest = Principle * Interest Rate * Time
a) Long term financing
Interest rate = 10.6% per year
Total Interest cost = $680,000 * 10.6% * 3 = $216,240
b) Short term financing
First year interest cost = 680,000 * 7.25% = $49,300
Second year interest cost = 680,000 * 11.90% = $80,920
Third year interest cost = 680,000 * 8.15% = $55,420
Total Interest Cost = $185,640
Clearly, Short term plan is less costly than the long-term plan.
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