Homework #6: Buy With Cash Or Finance A Purchase

Deciding whether to pay cash or finance a purchase. Use Worksheet 7.2. Matilda Edwards wants to by a home entertainment center. Compete with a big-screen TV DVD, and sound system the unit would cost $4500. Matilda has over $15,000 in a money market fund, so she can easily afford to pay cash for the whole thing ( the fund is currently paying 3 percent interest, and Matilda expects that yield to hold for the foreseeable future). To stimulate sales, the dealer is offering to finance the full cost of the unit with  36-month, simple interest installment loan at 6 percent.

Matilda wants to know whether she should pay cash for the home entertainment center or buy it on time. Matilda does not itemize deductions on her income tax. Briefly explain her best choice after completing the worksheet.


Cost of Borrowing
1.Terms of the loan
a. Amount of the loan
b. Length of the loan (in years)
c. Monthly payment
2.Total loan payments made
(monthly loan payment × length of loan in months)
$ – 0per month ×0months$ – 0YES
3.Less: Principal amount of the loan$ – 0
4.Total interest paid over life of loan
(line 2 — 3)$ – 010%
5.Tax considerations:25%
• Is this a home equity loan (where interest expenses can28%
be deducted from taxes)? . . . . . . . . . . . . . . . . . . . . . . .33%
• Do you itemize deductions on your federal tax returns?.35%
• If you answered yes to BOTH questions, then proceed
to line 6; if you answered no to either one or both of
the questions, then proceed to line 8 and use line 4 as
the after-tax interest cost of the loan.
6.What federal tax bracket are you in?
(use either 10, 15, 25, 28, 33, or 35%)
7.Taxes saved due to interest deductions
(line 4 × tax rate, from line 6:$ – 0×0%$ – 0
8.Total after-tax interest cost on the loan (line 4 – line 7)$ – 0
Cost of Paying Cash
9.Annual interest earned on savings (annual rate of interest earned
on savings × amount of loan:% ×$ – 0$ – 0
10.Annual after-tax interest earnings (line 9 × [1 – tax rate]
— e.g., 1 – 28% = 72%:$ – 0×%)$ – 0
11.Total after-tax interest earnings over life of loan
(line 10 × line 1b:$ – 0×0years)$ – 0
Net Cost of Borrowing
12.Difference in cost of borrowing vs. cost of paying cash
(line 8 minus line 11)$ – 0
BASIC DECISION RULE:Pay cash if line 12 is positive; borrow the money if line 12 is negative.
Note: For simplicity, compounding is ignored in calculating both the cost of interest and interest earnings.

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