Auer Food Company has decided to buy a new computer system with an expected life of three years. The cost is $400,000. The company can borrow $400,000 for three years at 14 percent annual interest or for one year at 12 percent annual interest. Assume interest is paid in full at the end of each year.
a. 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 12 percent rate? Compare this to the 14 percent three-year loan.
b. What if interest rates on the 12 percent loan go up to 18 percent in year 2 and 21 percent in year 3? What would be the total interest cost compared to the 14 percent, three-year loan?