The Reynolds Corporation buys from its suppliers on terms of 3/19, net 75. Reyno

Question

The Reynolds Corporation buys from its suppliers on terms of 3/19, net 75. Reynolds has not been utilizing the discounts offered and has been taking 75 days to pay its bills Mr. Duke, Reynolds Corporation vice president, has suggested that the company begin to take the discounts offered. Duke proposes that the company borrow from its bank at a stated rate of 25 percent. The bank requires a 15 percent compensating balance on these loans. Current account balances would not be available to meet any of this compensating balance requirement. a. Calculate the cost of not taking a cash discount. (Use a 360-day year. Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.) Cost of not taking a cash discount b. What is the effective rate of interest on the bank loan? (Use a 360-day year. Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.) Effective rate of interest c. Do you agree with Duke's proposal? No Yes

Explanation / Answer

a) Cost of not taking the discount

= [Discount%/(100% - Discount%)]*[360 days/Final due days - Discount period)]

= [3%/(100%-3%)*[360 days/(75 days-19 days)]

= (3/97)*(360 days/56 days) = 0.1988 or 19.88%

b) Effective rate of interest = Interest rate*(1-Compensating balance)

= 25%*(1-0.15) = 25%*0.85 = 21.25%

c) The effective cost of interest (i.e. 21.25%) is more than the cost of not taking the discount (i.e. 19.88%). Therefore, Reynolds corporation should continue to pay up in 75 days and not taking the discount.

Hence the answer is No.

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