Question

The Reynolds Corporation buys from its suppliers on terms of 2/11, net 60. Reynolds has not been utilizing the discounts offered and has been taking 60 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 16 percent. The bank requires a 12 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 the sake of calculations, have assumed Amount as $ 100000

Fund Requirement	1,00,000
Alternative 1- Cash Discount			Alternative 2- Loan
Cash Discount Terms	2/11, Net 60		Loan Amount	1,00,000
			Reqd Compensating Balance	12%
Left out Period
(60-11)	49		APR	16%
Total No. of Days	360		Interest Cost	16,000
No.of Times	7.35
Discount Cost	14,694		Total Finance Cost	16,000
Effective Rate	14.69%		Effective Rate	18.18%
Alternative 1	14.69%
Alternative 2	18.18%

Ms Duke's proposal for the company to take the discounts being offered seems fair, as the the effective rate is much lower than that of availing Loan.