Boatler Used Cadillac Co. requires $890,000 in financing over the next two years. The firm can borrow the funds for two years at 11 percent interest per year. Ms. Boatler decides to do forecasting and predicts that if she utilizes short-term financing instead, she will pay 7.25 percent interest in the first year and 12.55 percent interest in the second year. Assume interest is paid in full at the end of each year. A. Determine the lot al two-year interest cost under each plan.
Interest Cost
Long term fixed-rate plan
Short term variable-rate
B. Which plan is less costly?
1. Long term fixed-rate plan
2. Short-term variable-rate plan

A. Total two-year interest cost under long term fixed-rate plan is $195,800; while total two-year interest cost under short term variable-rate is $176,220.

B. Short-term variable-rate plan is less costly.

Explanation:

A. Determine the total two-year interest cost under each plan.

This can be determined for each of the plan as follows:

For Long term fixed-rate plan

Total two-year interest cost under long term fixed-rate plan = Amount required * Interest rate per year * Number of years = $890,000 * 11% * 2 = $195,800

For Short term variable-rate

First year interest cost under short term variable-rate = Amount required * First year interest rate = $890,000 * 7.25% = $64,525

Second year interest cost under short term variable-rate = Amount required * Second year interest rate = $890,000 * 12.55% = $111,695

Total two-year interest cost under short term variable-rate = First year interest cost + Second year interest cost = $64,525 + $111,695 = $176,220

Therefore, we have:

                                                         Interest Cost

Long term fixed-rate plan                   $195,800

Short term variable-rate                      $176,220

B. Which plan is less costly?

Since the total two-year interest cost under short term variable-rate of  $176,220 is less than $195,8000 total two-year interest cost under long term fixed-rate plan, the Short-term variable-rate plan is therefore less costly.