Question

The Reynolds Company buys from its suppliers on terms of 2/10, net 58. Reynolds has not been utilizing the discount offered and has been taking 70 days to pay its bills. The suppliers seem to accept this payment pattern, and Reynold’s credit rating has not been hurt. Mr. Duke, Reynolds Company’s vice-president, has suggested that the company begin to take the discount offered. Mr. Duke proposes the company borrow from its bank at a stated rate of 11 percent. The bank requires a 11 percent compensating balance on these loans. Current account balances would not be available to meet any of this required compensating balance.

a. Calculate the cost of not taking a cash discount. (Use 365 days in a year. Do not round intermediate calculations. Round the final answer to 2 decimal places.) Cost of not taking a cash discount %

b. Calculate the annual rate of interest if the company borrows from the bank. (Use 365 days in a year. Do not round intermediate calculations. Round the final answer to 2 decimal places.) Annual rate of Interest %

Answer 1

Answer :

a)Calculation of Cost of not taking a discount

Cost of not taking a cash discount = [Discount % / (100% - Disc.%)] × [365 / (Final due date - Discount period)]                                                                      =    (2 % / 98%)   X {365 / (58 days (-) 10days)                                                                      =     0.02 / 98% X 365/ 48                                                                     = 0.1552

Cost of not taking a cash discount = 0.1552   = 15.52%

b) calculation of Effective rate of interest with a 11%

Effective Annual rate of interest with a 11% compensating balance requirement                                                                         = Interest rate/(1 – C)                                                                         = 11% / (1-11%)                                                                         = 11% / 0.89                                                                         = 0.1236

Effective Annual rate of interest   =   0.1236   = 12.36%