Question

Simmons Corp. can borrow from its bank at 20 percent to take a cash discount. The terms of the cash discount are 1.5/17, net 60.

a. Compute the cost of not taking the cash discount. (Use a 360-day year. Do not round intermediate calculations. Input your final answer as a percent rounded to 2 decimal places.)

b. Should the firm borrow the funds? Yes-No

Answer 1

The terms of cash discount of 1.5/17, net 60 means that, if the customers pay within 17 days they will receive a discount of 1.5% by the vendor else they need to pay off the net of their accounts payable within 60 days. This is called as trade credit.

Part 1:

The annualized percentage of savings is calculated using the formula below:
(Discount Rate / (1 - Discount Rate)) * (360 days / (Maximum Non-Discounted Days - Maximum Discounted Days))
Here, discount rate is 1.5%.
Maximum Discounted Days=17 days
Maximum Non-Discounted Days=60 days
Now, (Discount Rate / (1 - Discount Rate)) * (360 days / (Maximum Non-Discounted Days - Maximum Discounted Days))
=(1.5%/(1-1.5%))*(360/(60-17))
=(.015/(1-.015))*(360/43)
=(.015/0.985)*(360/43)
=0.015228426*8.372093023

=0.127493799 or 12.75% (rounded upto 2 decimal places)
So, the cost of not taking the cash discount=12.75%

Part 2:
Given that, cost of borrowing is 20%
Annualized savings as we calculated is 12.75%, and it is lower than the cost of borrowing the funds at 20%.
So, the firm should not borrow the funds.