Question

The Reynolds Company buys from its suppliers on terms of 3/10, net 61. Reynolds has not been utilizing the discount offered and has been taking 73 days to pay its bills. The suppliers seem to accept this payment pattern, and Reynold's credit rating has not been hurt. Mr. Duke, Reynolds Company's vice president, has suggested that the company begin to take the discount offered. Mr. Duke proposes the company borrow from its bank at a stated rate of 15 percent. The bank requires a 14 percent compensating balance on these loans. Current account balances would not be available to meet any of this required compensating balance. a. Calculate the cost of not taking a cash discount (Use 365 days in a year. Do not round Intermediate calculations. Round the final answer to 2 decimal places.) Cost of not taking a cash discount b. Calculate the annual rate of interest if the company borrows from the bank. (Use 365 days in a year. Do not round intermediate calculations. Round the final answer to 2 decimal places.) Annual rate of interest c. Do you agree with Mr. Duke's proposal? Yes No

Answer 1

Answer -

As per given information

Discount = 3%

Final due date = 61 days

Discount period = 10 days

Bank stated rate = 15%

Required compensating balance (C) = 14%

a. Answer -

Cost of not taking cash discount = 21.83%

Calculation :

Cost of not taking cash discount = [Discount % / (100% - Discount %)] * [360 / (Final due date - Discount period)]

Cost of not taking cash discount = [3% / (100% - 3%)] * [360 / (61 - 10)]

Cost of not taking cash discount = [3% / 97%] * [360 / 51]

Cost of not taking cash discount = 21.83%

b. Answer -

Annual rate of interest = 17.44%

Calculation :

Annual rate of interest = Interest rate / (100% - C)

Annual rate of interest = 15% / (100% - 14%)

Annual rate of interest = 17.44%

c. Answer -

Yes,

The annual cost of loan, 17.44% is less than the cost of passing up the discount, 21.83%. Reynolds company should borrow funds from the bank and pay the invoice early in order to take advantage of discount.