Question

A firm has the following choices to finance its inventory purchase:

•Credit terms of 2/15 net 45 EOM

•A single payment note with $400,000 principal and an 8% annual interest rate payable in 45 days

•A discount loan with $400,000 principal and 7.85% annual interest rate payable in 45 days

1.Explain what the credit terms mean.

2.Calculate the cost of not taking the discount.

3.Calculate the annualized cost of (a) the single payment note and (b) the discount loan.

4.Of the available options, how should the firm finance its inventory purchase? Should it take the discount or not? If it does, how should it finance the purchase? Support your answer.

Answer 1

A firm has the following choices to finance its inventory purchase:

•Credit terms of 2/15 net 45 EOM

•A single payment note with $400,000 principal and an 8% annual interest rate payable in 45 days

•A discount loan with $400,000 principal and 7.85% annual interest rate payable in 45 days

1. Explain what the credit terms mean.

Credit terms are the payment requirements stated on an invoice bill. It is common for sellers to offer early payment terms to their customers in order to speed up the flow of incoming cash. The credit term include the amount of credit extended to the customer, the time period within which payments must be made by the customer, early payment discount terms and the penalty to be charged if payments are late.

2. Calculate the cost of not taking the discount.

cost of not taking the discount. = 365 / ( Discount period - actual payment period ) *

discount rate / 100 - discount rate

Where,

Discount period = 15 days

actual payment period = 45 days

discount rate = 2%

cost of not taking the discount. = (365 / ( 45 - 15 ) ) * ( 2 / 100 - 2)

cost of not taking the discount. = ( 365 / 30 ) * ( 2 / 98 )

cost of not taking the discount. = 12.166 *   0.020 = 0.2483 = 24.83%

3. .Calculate the annualized cost of (a) the single payment note and (b) the discount loan.

the single payment note

Annualized rate are directly given = 8%

(b) the discount loan.

Effective Rate of Discounted Interest = Interest on the Principal Amount of the Loan / ( Principal Amount – Interest “Withheld” )

Effective Rate of Discounted Interest = 31400 / ( 400000 - 31400)

Effective Rate of Discounted Interest = 31400 / 368600 = 0.0852 *100 = 8.52

4. Of the available options, how should the firm finance its inventory purchase? Should it take the discount or not? If it does, how should it finance the purchase?

They take the trade credit. And after that they take single payment note for 45 days to take the advantage of discount. They should take discount, because the cost of not taking discount is higher than. And they can borrow money from financial institution with lowest cost. After purchase with in 15 days they pay the cash and take discount. Those needed money they can borrow from other lenders.