You are going to use your knowledge of present value to determine the costs of u

Question

You are going to use your knowledge of present value to determine the costs of using store financing vs introductory credit card offers. Assume that you are making these decisions in the first few months of your full time employment after college. For both options, you are required to pay 7% sales tax. Assume that you have $1,200 saved in your saving account. Your saving account pays you 2% interest. Assume the market interest rate is currently 6%. Even though the financing compounds more frequently, in this assignment, assume the charges are compounded annually. Purchase options: · Television and home theater: You have decided to upgrade your entertainment system to include a 50” 3D-LED-Smart TV for $1,800, a Blu-ray home theater system for $400, and assorted mounting and cables for $250. The credit terms posted for Best Buy apply to this purchase. For store financing, assume 12 months no interest. Suppose the current discount is 8% for purchases made using their card. 2. Option 1: Store financing special a. Read the store financing option for the store that you have chosen above. Note that interest starts accruing from the date of purchase. If you have not paid the entire balance, the full interest is charged to you. Before you make the decision, you should know the costs and benefits. Calculate the amount of interest charge you will accrue if you do not pay off the balance within the offer period. Discount that figure to calculate the interest charge in present value terms. If you take the store financing, you can leave your $1,200 in the saving account for the offer period and earn interest. How much interest will you earn? What is the present value of your saving account balance at the end of the offer period? Calculate the net cost to you in present value terms if you pay off the balance before the offer period ends (PV cost – PV of savings). 3. Option 2: Store Credit Cards a. Review the credit card terms from the store you chose. Let’s assume the interest is compounded annually at the beginning of the year for ease of calculation. (In real life, it’s compounded either daily or monthly.) At the store, you would put the entire balance (minus the discount) on the new credit card. Credit cards do not have a 12 month grace period so you cannot avoid the interest on the credit card. You can use the $1,200 in your saving account to make a payment immediately and reduce the credit card balance, or you can leave the savings at the bank and earn interest for either one or two more years. Which would you choose to do? Calculate the first year’s interest charges using the credit card rate and your total balance. Think of this as the ceiling on the amount you would likely pay. Note: you should use your answer from above about whether to make the initial payment of $1,000 to reduce the balance on which interest is calculated. 4. After calculating the costs under options 1 and 2, write up a summary of your findings. Include the calculations you made. Make sure to tell me which option you would choose for financing. MY BEST BUY CREDIT CARD PREFERRED and MY BEST BUY CREDIT CARD Interest Rates and Interest Charges Annual Percentage Rate (APR) for Purchases 25.24% or 27.99% based upon your credit worthiness. These APRs will vary with the market based on the Prime Rate. 11.90% for select purchases eligible for the 48 month reduced rate credit plan. How to Avoid Paying Interest on Purchases Your due date is at least 25 days after the close of each billing cycle. We will not charge you any interest on purchases if you pay your entire balance by the due date each month. Minimum Interest Charge If you are charged interest, the charge will be no less than $2. For Credit Card Tips from To learn more about factors to consider when applying for or using a the Consumer Financial credit card, visit the website of the Consumer Financial Protection Protection Bureau Bureau at http://www.consumerfinance.gov/learnmore Fees Penalty Fees . Late Payment . Returned Payment Up to $25. Up to $35. How We Will Calculate Your Balance: We use a method called "daily balance." The store sales associate or store website will identify which purchases are eligible for the reduced rate credit plan.

Explanation / Answer

PV = F.V/(1+R)

As the discounting rate is absent, assume it as same as market Intt. rate i.e 6%p.a

Amount Earned

Balance in Savings Account = $1200
Interest @ 2%p.a (1200*2%) = $24

Account Balance at the end of offer Period = $1200 + $24 = $1224
PV of Interest Earned = 24/1.06 = $22.64
PV of saving account balance = 1224/1.06 = $1154.72

Net Cost if the balance is paid within the offer Period
Net Cost = NPV of Outfow
PV of Purchase Amount = 2621.50/1.06 = $2473.11
Less: PV of Interest Earned = $24
Total = $2450.47
(Its been assumed payment is made on last day of offer)

Option 2: Credit Card Score
Current Credit card Discount - 8%
Net Amount to be paid - $2621.50*92% = $2411.78

Assume the purchase is eligible for reduced rate of 11.90%
As the interest rate of credit card is higher than the saving account interest rate. So it is benefecial to reduce Credit Card Balance by paying $1,200 from savings account.

Interst charged on Credit Card Balance @ 11.90%
$1211.78*11.90% = 144.20

Net Cost (Assuming Credit card balance is paid at the end of 12 months)
NPV of outflow
Down Payment = $ 1200
PV of Credit Card Payment = 1211.78/1.06 = $ 1143.19
PV of Credit Card Interest = 144.2/1.06 = $ 136.04
TOTAL = $ 2479.23

SUMMARY:
As the NPV of option 1 is less than the NPV of option 2, so it is suggested that person should opt for Store Financing option and earn money on its Saving Account.

Note: Its been assumed that discount rate is equal to the market rate, student may also use the saving account interest rate as discount rate opting the view that at this rate person can earn money. If student opt for latter then the answer should be adjusted accordingly.

Total payment to be made (in $) 3D Smart LED         1,800.00 Blu-ray home theatre System             400.00 Cables             250.00 Total         2,450.00 Sales Tax @ 7%             171.50         2,621.50

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