Stern Educational TV,Inc.,has decided to buy a new computer system with an expec

Question

Stern Educational TV,Inc.,has decided to buy a new computer system with an expected life of three years at a cost of $200,000. The company can borrow $200,000 for three years at 12% annual interest or for one year at 10 percent annual interest.

A) How much would the firm 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 10% rate? Compare this to the 12% three year lona

B) What if interest rates on the 10 percent loan go up to 15 % in the second year and 18% in the third year? What would be the total interest cost compared to the 12%, three year loan?

Explanation / Answer

Solution:

a. If Rates Are Constant $200,000 borrowed 12% per annum 3 years = $72,000 interest cost (long-term) $200,000 borrowed 10% per annum 3 years = $60,000 interest cost (short-term) $72,000 $60,000 = $12,000 interest savings borrowing short-term

b. If Short-term Rates Change 1st year 2nd year 3rd year $200,000 .10 $200,000 .15 $200,000 .18 Total = = = = $20,000 $30,000 $36,000 $86,000 $86,000 $72,000 = $14,000 extra interest costs borrowing short-term one year at a time.

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