James M. Jones Jr. is an entrepreneur and the founder of Tasty Cakes Bakery. During the last year, Tasty Cakes generated $40,000 in operating cash flows, paid $10,000 in capital expenditures (as he does almost every year), and paid $5,000 in dividends. Jones is interested in significantly expanding this year. To do so, he needs to spend $100,000 on equipment in addition to his normal capital expenditures. He believes that if he buys the equipment, his operating cash flows will surely increase by 25% and possibly could double. He has spoken with the bank, which has offered the following two installment note options where an equal amount of principal is due each year:
Option 1: Two-year, 5%, $100,000 installment note
Option 2: Six-year, 10%, $100,000 installment note
Required
a. Calculate Tasty Cake's free cash flow.
b. Identify the advantages and disadvantages of each option the bank provides.
c. Which option should Jones choose and why?