Question

Exercises #11 1. Xtra Corporation needs $50,000 for three months to finance its working capital. The company has arranged a short-term loan with a bank. The bank charges 8% annual interest rate with interest paid in advance. The bank also requires 5% of the borrowed amount as a compensating balance. Assume Xtra does not have money to serve as a compensating balance and pay interest upfront 1.1 How much Xtra have to borrow? 1.2 Find effective cost of bank loan 2.Xtra buys raw materials from its supplier with 3/10 net 45 credit term. Find effective cost of not taking cash discount and pay on the net day.

Answer 1

Answer 1.1:

Amount borrowed is = X

Hence:

Interest = X * 8%/2 = 0.02X

Compensating balance = X * 5% = 0.05X

Amount Required = 50000

Hence:

=> X = 50000 + 0.05X + 0.02X

=> 0.93X = 50000

X = 50000 / 0.93

= $53,763.44

Hence amount Xtra has to borrow = $53,763.44

Answer 1.2:

Cash inflow at time 0 = $50,000

Xtra has to repay loan amount at the end three months

Amount it has to repay = Amount borrowed - Compensating balance it has with bank = $53,763.44 - $53,763.44 * 5%

= $51,075.27

Now to get Quarterly interest rate we will use RATE function of excel:

= RATE (nper, pmt, pv, fv, type)

= RATE(1, 0, 50000, -51075.27, 1)

= 2.15054%

Effective cost of bank loan = (1 + 2.15054%) ^4 - 1

= 8.88%

Effective cost of bank loan = 8.88%

Answer 2:

Effective cost of not taking discount = (Discount % / (1 - Discount%) * 365 / (Normal due days - early payment day)

= (3% / (1 - 3%) * 365 / (45 - 10)

= 32.25%

Effective cost of not taking discount = 32.25%