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Chapter 3: Q7BP (page 185)

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

Expert verified

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

Step by step solution

01

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 in the first year = 7.75% per annum

The interest rate on short-term financing in the second year = 13.55% per annum

02

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

The cost of financing is $204,000.

CostofFinancing=Borrowedfunds×Interestrate×Time=$850,000×$12%p.a×2=$204,000

03

Cost of financing using short-term financing

The cost of financing is $181,050.

CostofFinancing=Borrowedfunds×Interestrate×Time=($850,000×$7.75%p.a×1)+($850,000×$13.55%p.a×1)=$181,050

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Most popular questions from this chapter

Sauer Food Company has decided to buy a new computer system with an expected life of three years. The cost is \(150,000. The company can borrow \)150,000 for three years at 10 percent annual interest or for one year at 8 percent annual interest.

How much would Sauer Food Company save in interest over the three-year life of the computer system if the one-year loan is utilized and the loan is rolled over (reborrowed) each year at the same 8 percent rate? Compare this to the 10 percent three-year loan. What if interest rates on the 8 percent loan go up to 13 percent in year 2 and 18 percent in year 3? What would be the total interest cost compared to the 10 percent, three-year loan?

Fast Turnstiles Co. is evaluating the extension of credit to a new group of customers. Although these customers will provide \(180,000 in additional credit sales, 12 percent are likely to be uncollectible. The company will also incur \)16,200 in additional collection expense. Production and marketing costs represent 72 percent of sales. The firm is in a 34 percent tax bracket and has a receivables turnover of four times. No other asset build-up will be required to service the new customers. The firm has a 10 percent desired return.

a. Calculate the incremental income after taxes and the return on incremental investment. Should Fast Turnstiles Co. extend credit to these customers?

Colter Steel has \(4,200,000 in assets.

Temporary current assets

\)1,000,000

Permanent current assets

\(2,000,000

Fixed assets

\)1,200,000

Total assets

\(4,200,000

Short-term rates are 8 percent. Long-term rates are 13 percent. Earnings before interest and taxes are \)996,000. The tax rate is 40 percent. If long-term financing is perfectly matched (synchronized) with long-term asset needs, and the same is true of short-term financing, what will earnings after taxes be? For a graphical example of perfectly matched plans, see Figure 6-5.

By using long-term financing to finance part of temporary current assets, a firm may have less risk but lower returns than a firm with a normal financing plan. Explain the significance of this statement.

Henderson Office Supply is considering a more liberal credit policy to increase sales, but expects that 9 percent of the new accounts will be uncollectible. Collection costs are 6 percent of new sales, production and selling costs are 74 percent, and accounts receivable turnover is four times. Assume income taxes of 20 percent and an increase in sales of $65,000. No other asset build-up will be required to service the new accounts.

e. Given the income determined in part b and the investment determined in part d, should Henderson extend more liberal credit terms?
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