Question

Your startup is currently cash-constrained, and you must make a decision about whether to delay paying one of its suppliers, or take out a loan. You owe the supplier $11000 with terms of 5/10 Net 40, so the supplier will give you a 5% discount if you pay today (when the discount period expires). Alternatively, you can pay the full $11000 in one month when the invoice is due. You are considering three options:

Alternative A: Forgo the discount on its trade credit agreement, wait and pay the full $11000 in one month.
Alternative B: Borrow the money needed to pay its supplier today from Bank A, which has offered a one-month loan at an APR of 12%. The bank will require a (no-interest) compensating balance of 5% of the face value of the loan and will charge a $100 loan origination fee. Because your startup has no cash, you will need to borrow the funds to cover these additional amounts as well.
Alternative C: Borrow the money needed to pay its supplier today from Bank B, which has offered a one-month loan at an APR of 15%. The loan has a 1% loan origination fee, which again you will need to borrow to cover.

For each alternative, what is the amount owed in one month? Which alternative is the cheapest source of financing for your startup?

a. Alternative A: the amount owed in one month is $. (round to full $)

b. Alternative B: the amount owed in one month is $. (round to full $)

c. Alternative C: the amount owed in one month is $. (round to full $)

d. The cheapest source of financing is alternative . (fill in "A", "B", or "C")

Answer 1

Given: Owe to supplier = $11000 with terms 5/10 Net 40. It means that, if the bill is paid within 10 days, you get 5% discount or pay the full amount in 40 days.Total cost of financing in

a) Alternative A: You pay the full amount $11,000 in one month. So, the total cost is $11,000.

b) Alternative B: If you pay the money today, then you get a discount of 5% from supplier, which is $550, so the total due is $11000 - $550 = $10450.

You need to borrow this money from Bank A @ 12% annual interest, which is 12%/12 for one month = 1%. So the total money paid to bank is $10450 * (1 + 1%) = $10554.5.

You also borrow 5% of face value of your loan to maintain a compensating balance in bank, which is 5% of 10450 = $ 522.5. Total cost of this loan for one month is 522.5 * (1.01) = $ 527.7.

and you also pay $100 loan origination fee.

So , the total cost of financing in alternative B = $10554.5 + $527.7 + $100 = $11182.2.

c) Alternative C: If you pay the money today, then you get a discount of 5% from supplier, which is $550, so the total due is $11000 - $550 = $10450.

You need to borrow this money from Bank A @ 15% annual interest, which is 15%/12 for one month = 1.25%. So the total money paid to bank is $10450 * (1 + 1.25%) = $10580.6

and you also pay loan origination fee of 1% of loan amount, which is $104.5. After borrowing this amount also from bank, you will pay total 104.5 * (1 +1.25%) = $105.8.

So , the total cost of financing in alternative C = $10580.6 + $105.8 = $10686.4

d) So, alternative C is the cheapest option for financing this money.