CASE STUDY (Math)

The Situation

Pay cash or take out a loan? That is the question the purchasing manager for Lightning Wholesale faces today. Lightning Wholesale needs to replace its fleet of 10 forklifts for its warehouse operations. After shopping around and putting out a request for quotes, it has chosen Combilift as its supplier. The purchasing manager for Lightning Wholesale has been informed that the company does have the cash available to pay off the debt immediately. Alternatively, Lightning Wholesale could take out a loan and finance the purchase. The purchasing manager wonders what recommendation she should make pay cash or take the loan? She knows she will need to support this decision with facts to her superiors.

The Data

The quote from Combilift for the fleet of forklifts was for $225,000 inclusive of all taxes, delivery, and other costs.

The purchase could be alternatively financed by taking out a loan with month-end payments over three years at 4.79% compounded monthly.

Prevailing interest rates on three-year investments are sitting at 5.95% compounded annually.

Important Information

Businesses have other considerations in making these decisions, such as interest expense deductions on loans or interest taxes payable on investments. For purposes of this analysis, though, focus solely on the financial decision being made, and do not factor these other components into the decision.

Your Tasks

1. Many people would not even consider taking the loan since they do not want to be paying interest on purchases. From a financial perspective, explain why this decision is not as simple as choosing not to pay interest. (Hint: Think about the interest rate.)

2. Calculate the loan payment amount if Lightning Wholesale pursued the loan alternative. What would be the amount of the final loan payment?

3. If Lightning Wholesale wanted to invest a single amount of money today to make the payments on the loan, what amount today must be invested? (Hint: Calculate the present value of the loan payments using the investment rate of return.)

4. Based on your calculations, what should the purchasing manager recommend? How much better is the chosen alternative in today's dollars?

5. Can you develop a general rule (exclusive of other considerations) to help decide more easily between paying cash or financing? (Hint: Try the above calculations using a loan rate of 6.79% instead of 4.79% and see what decision is made.)