Question

Hand-to-Mouth (H2M) is currently​ cash-constrained, and must make a decision about whether to delay paying one of its​ suppliers, or take out a loan. They owe the supplier $ 11,500 with terms of 1.8​/10 Net​ 40, so the supplier will give them a 1.8 % discount if they pay by today​ (when the discount period​ expires). ​ Alternatively, they can pay the full $ 11,500 in one month when the invoice is due. H2M is considering three​ options:

Alternative​ A: Forgo the discount on its trade credit​ agreement, wait and pay the full $ 11,500 in one month.

Alternative​ B: Borrow the money needed to pay its supplier today from Bank​ A, which has offered a​ one-month loan at an APR of 11.6 %. The bank will require a​ (no-interest) compensating balance of 5.3 % of the face value of the loan and will charge a $ 95 loan origination fee. Because H2M has no​ cash, it will need to borrow the funds to cover these additional amounts as well.

Alternative​ C: Borrow the money needed to pay its supplier today from Bank​ B, which has offered a​ one-month loan at an APR of 14.8 %. The loan has a 0.5 % loan origination​ fee, which again H2M will need to borrow to cover.

Answer 1

Alternative A – ( Forgo the discount)

The question read as 1.8/10 Net 40:

Interest rate for the period of additional 30 days = 1.8/(100-1.8) = 1.83%

Effective annual cost = (1.0183)^(365/30) – 1 = 24.69%

Alternative B – (Borrow from Bank A)

Receipt = Loan amount - Compensating balance - Origination fee

= 11500 – (5.3% of 11500) – 95

= 10796

Payment on closure of loan          = Loan amount - Compensating balance + interest

= 11500 - (5.3% of 11500) + 11500*11.60*30/365

= 11000

30 days interest rate = 11000/10796 - 1 =1.89%

Effective annual cost = (1.0189)^(365/30) -1 =25.58%

Alternative C – (Borrow from Bank B)

Receipt = Loan amount - Origination fee

= 11500 – (0.5% of 11500)

= 11443

Payment on closure of loan          = Loan amount+ interest

= 11500 + (11500*14.80*30/365)

= 11640

30 days interest rate = 11640/11443 - 1 =1.72%

Effective annual cost = (1.0172)^(365/30) -1 = 23.06%

As Effective Annual Cost is lowest under Alternative C, Hand-to-Mouth (H2M) should borrow the money from Bank B and pay off the supplier.