In: Accounting
Simple Simon's Bakery purchases supplies on terms of 1.4/10 comma net 25. If Simple Simon's chooses to take the discountoffered, it must obtain a bank loan to meet its short-term financing needs. A local bank has quoted Simple Simon's owner an interest rate of 11.1% on borrowed funds. Should Simple Simon's enter the loan agreement with the bank and begin taking thediscount? (Use 365 days for a year.) Should Simple Simon's enter the loan agreement with the bank and begin taking the discount? (Select the best choicebelow.)
Answer)
Credit terms: 1.4/10, net 25
The above terms indicate that if Simple Simon’s bakery makes the payment within 10 days from the date of purchase it can have cash discount of 1.40%, else it will have to make payment within 25 days.
Suppose in the above case the bakery purchases goods of $ 7,300, the following two options are available:
Option 1: Let go the discount and make payment on the 25th day after the purchase.
Cash outflow: In this case the total amount of cash outflow will be $ 7,300
Option 2: Borrow Short term funds from Bank on the 10th day and make payment in the same day.
In this case, total cash outflow will be as follows:
Cash outflow = Amount paid to seller + Interest paid to bank
= $ 7,197.80 + $ 33.30
= $ 7,231.10
Decision: Since the cash outflows under option 2 (i.e. $ 7,231.10) is less than option 1 (i.e. $ 7,300), Simple Simon’s bakery should enter the loan agreement with the bank and take the discount on early payment.
Working Note:
Amount paid to seller = $ 7,300 – ($ 7,300 X 1.40%)
= $ 7,197.80
Note: Since the payment is made in the 10th day, cash discount is availed
Interest paid to Bank = $ 7,300 X 11.1% X 15/365
= $ 33.30
Note: Since short term funds of $ 7,300 were borrowed from bank on 10th day after purchase and repaid on 25th day after purchase interest for 15 days is charged by the bank