Question

Kuznets Rental Center requires $500,000 in financing over the next two years. Kuznets can borrow long-term at 8 percent interest per year for two years. Alternatively, Kuznets can borrow short-term and pay 6 percent interest in the first year, followed by their paying 9 percent interest in the second year. Assuming Kuznets pays off the accrued interest at the end of each year, which of the following statements is true?

A. Kuznets will end up paying more in total interest under the long-term financing plan.

B. Kuznets will end up paying less in total interest under the long-term financing plan.

C. Kuznets will pay less in the first year under the long-term financing plan.

D. Kuznets will pay less in the second year under the short-term financing plan.

Answer 1

Kuznets Rental Center should choose short-term financing as it would result in $5,000 less being paid in total interest when compared to long-term financing at a constant 8 percent rate over two years.

Step-by-step explanation:

When deciding whether Kuznets Rental Center should opt for long-term financing at an 8 percent interest rate or short-term financing at 6 percent the first year and 9 percent the second year, we need to compare the total interest paid under both scenarios.

With long-term financing, the interest paid each year on the $500,000 would be $40,000 (8% of $500,000), leading to a total of $80,000 over the two years. If Kuznets opts for short-term borrowing, they would pay $30,000 the first year (6% of $500,000) and $45,000 the second year (9% of $500,000) for a total of $75,000 over the two years.

Comparing the totals, Kuznets would end up paying $5,000 less in interest with the short-term financing plan. Therefore, the correct statement is:

Long-term financing: $500,000 x 0.08 = $40,000 per year x 2 years = $80,000 total interest paid

Short-term financing: First year: $500,000 x 0.06 = $30,000 interest. Second year: ($500,000 + $30,000) x 0.09 = $47,700 interest. Total interest paid: $30,000 + $47,700 = $77,700

Therefore, Kuznets will end up paying more in total interest under the long-term financing plan (Option A).