Question

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.)
  

   

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.)
  

  
  
c. Do you agree with Duke's proposal?

Answer 1

Based on the given data, pls find below workings for (a) and (b);

Since the funding requirement is not provided, have assumed an amount of $ 100000 for arriving at the calculations;

Based on the below, the effective rate using Cash discount is a bit costlier than that of the Loan option;

Hence, Ms Duke's suggestion for going for cash discount is not recommended.

Fund Requirement	1,00,000
Alternative 1- Cash Discount			Alternative 2- Loan
Cash Discount Terms	2/18, Net 50		Loan Amount	1,00,000
			Reqd Compensating Balance	15%
Left out Period
(50-18)	32		APR	18%
Total No. of Days	360		Interest Cost	18,000
No.of Times	11.25
Discount Cost	22,500		Total Finance Cost	18,000
Effective Rate	22.50%		Effective Rate	21.18%
Alternative 1	22.50%
Alternative 2	21.18%

Discount Cost = Amount * Cost % * No.of Times = 100000*2%*11.25 = 22500;

Effective Rate = 22500/100000 = 22.5%;

Loan - Effective Rate = Interest cost / (Principal - Principal*Compensating balance) = 18000/(100000-100000*15%) = 21.18%