Question
Use worksheet 7.2 Emma Caldwell wants to buy a home entertainment center. Complete with a big-screen TV, DVD, and sound system, the unit would cost
Use worksheet 7.2
Emma Caldwell wants to buy a home entertainment center. Complete with a big-screen TV, DVD, and sound system, the unit would cost $4,500. Emma 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 5 percent interest, and Emma 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 a 36-month installment loan at 4 percent, simple. Emma wants to know: Should she pay cash for the home entertainment center or buy it on time? (note: Assume that Emma is in the 28 percent tax bracket and that she itemizes deductions on her tax returns.) Briefly explain.
BUY ON TIME OR PAY CASH | |||||||||
Name | Date | ||||||||
Cost of Borrowing | |||||||||
1. | Terms of the loan | ||||||||
a. Amount of the loan | |||||||||
b. Length of the loan (in years) | 3 | ||||||||
c. Monthly payment | |||||||||
2. | Total loan payments made | ||||||||
(monthly loan payment length of loan in months) | |||||||||
$ - | per month | 36 | months | $ - | |||||
3. | Less: Principal amount of the loan | $ - | |||||||
4. | Total interest paid over life of loan | ||||||||
(line 2 3) | $ - | ||||||||
5. | Tax considerations: | ||||||||
Is this a home equity loan (where interest expenses can | |||||||||
be deducted from taxes)? . . . . . . . . . . . . . . . . . . . . . . . | NO | ||||||||
Do you itemize deductions on your federal tax returns?. | NO | ||||||||
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%) | 35% | ||||||||
7. | Taxes saved due to interest deductions | ||||||||
(line 4 tax rate, from line 6: | $ - | 35% | $ - | ||||||
8. | Total after-tax interest cost on the loan (line 4 - line 7) | $ - | |||||||
Cost of Paying Cash | |||||||||
9. | Annual interest earned on savings (annual rate of interest earned | ||||||||
on savings amount of loan: | 4 | % | $ - | $ - | |||||
10. | Annual after-tax interest earnings (line 9 [1 - tax rate] | ||||||||
e.g., 1 - 28% = 72%: | $ - | 28 | %) | $ - | |||||
11. | Total after-tax interest earnings over life of loan | ||||||||
(line 10 line 1b: | $ - | 3 | years) | $ - | |||||
Net Cost of Borrowing | |||||||||
12. | Difference in cost of borrowing vs. cost of paying cash | ||||||||
(line 8 minus line 11) | $ - | ||||||||
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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