In: Finance
The Reynolds Corporation buys from its suppliers on terms of 2/18, net 50. Reynolds has not been utilizing the discounts offered and has been taking 50 days to pay its bills.
Ms. Duke, Reynolds Corporation's vice president, has suggested that the company begin to take the discounts offered. Duke proposes that the company borrow from its bank at a stated rate of 18 percent. The bank requires a 15 percent compensating balance on these loans. Current account balances would not be available to meet any of this compensating balance requirement.
a. Calculate the cost of not taking a cash discount. (Use a 360-day year. Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
cost of not taking a cash discount | % |
b. What is the effective rate of interest on the bank loan? (Use a 360-day year. Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
Effective rate of interest | % |
Let the credit obtained from supplier be $ 100,000
Amount | Amount | |
If cash discount not taken | ||
Amount repayable at the end of 50 days | $100,000.00 | |
Amount of loan to be taken including compensation reserve (100000*100/85) | $117,647.06 | |
Interest payable on such loan (117647.06*18%) | $21,176.47 | |
% of expense incurred for 100000 (21176.47/100000) | 21.18% | |
If cash discount taken | ||
Amount repayable at the end of 18 days (100000*98%) | $98,000.00 | |
Amount of loan to be taken including compensation reserve (98000*100/85) | $115,294.12 | |
Interest payable on such loan (115294*18%) | $20,752.94 | |
Amount of discount received for prepayment | $(2,000.00) | |
Amount of interest payable for additional 32 days i.e 50-18 days (115294.12*32/360*18%) | $1,844.71 | |
Total expense incured on credit obtained from suppliers | $20,597.65 | |
% of expense incurred for 100000 (21176.47/100000) | 20.60% | |
Solution (a) The cost of not taking the cash discount is less than 1% of total credit obtained
Solution (b) The effective rate of interest on the bank loan is 21.18%