Question

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

•Credit terms of 1/20 net 40 EOM

•A single payment note with $500,000 principal and an 7.5% annual interest rate payable in 40 days

•A discount loan with $500,000 principal and 6.95% annual interest rate payable in 40 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

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Answer:

1)

The Term 1/20net ,40EOM states that if a customer makes payment within 20 days from EOM in which invoice is received then 1% discount can be given .However maximum days allowed for payment is 40 days from EOM exceeding which calls for extra penalty costs or interest payment .

2)

Cost of not taking discount is given by the formula as

[Discount % /(100-Discount %) ] *[365/(Maximum days allowed -discount days allowed ) ]

            = [1/(100-1) ] * [365/(40 - 20)]

           = [1/0.99 ]* [365 /20]

           = .01010* 18.25

           = .18.43%

3)

a)Interest Paid on single payment note is given by the computation as  Principal amt * interest *n/365

                      = 500000 * 7.5%*40/365

                     = 4109.59.

b)

Discount on note = principal *r *n/365

                   = 500000 * .0695*40/365

                   = 3808.22

4)

Since the cost of financing under Alternative 3 -Discount loan is lowest ,it should be choosen .

Financing of inventory through discount note will be chosen as it is the best option here