Question

Riley Co. is considering a short-term or long-term financing plan for $4,000,000 in assets. They expect the following one-year rates over the next three years: 6.5%, 7.75%, and 9%. Their long-term interest rate will be 7.5% for the three years. Assuming the rates follow their expectations, what will be the difference in interest costs over the three years?

A. Long-term interest will be $30,000 more than short-term interest.

B. Long-term interest will be $30,000 less than short-term interest.

C. Long-term interest will be $140,000 less than short-term interest.

D. None of the options

Answer 1

Opting for long-term financing would save Riley Co. $30,000 in interest costs compared to using short-term financing. Option B, Long-term interest will be $30,000 less than short-term interest, is correct.

Step-by-step explanation:

To calculate the difference in interest costs over the three years, we need to compare the short-term and long-term financing plans. The short-term financing plan will have different interest rates each year: 6.5%, 7.75%, and 9%. The long-term financing plan will have a fixed interest rate of 7.5% for all three years. We can calculate the interest costs for each plan and then find the difference.

For the short-term financing plan, the interest costs over three years can be calculated as follows:

• Year 1: $4,000,000 * 6.5% = $260,000
• Year 2: $4,000,000 * 7.75% = $310,000
• Year 3: $4,000,000 * 9% = $360,000

The total interest costs for the short-term financing plan are:

= $260,000 + $310,000 + $360,000

= $930,000

For the long-term financing plan, the interest costs over three years can be calculated as follows:

• = $4,000,000 * 7.5%
• = $300,000 per year

The total interest costs for the long-term financing plan are:

= $300,000 * 3

= $900,000

Therefore, the difference in interest costs over the three years is:

= $930,000 - $900,000

= $30,000.

Therefore, the long-term interest will be $30,000 less than the short-term interest over the three-year period. This suggests that opting for long-term financing would save Riley Co. $30,000 in interest costs compared to using short-term financing.

Correct answer: Option B