A company buys $10 million of materials (net of discount) on terms 3/5, net 60,

Question

A company buys $10 million of materials (net of discount) on terms 3/5, net 60, and it currently pays on the 5th day & takes discounts. The company plans to expand, which will mean add'l financing. 1) If the company decides to forgo discounts, could it obtain much add'l credit? 2) What would be the nominal & effective cost of that credit? 3) What would be the effective cost of the bank loan if the company could get the funds from a bank at a rate of 8% and if the interest was paid monthly? All of this shoudl be based on 365 day year. 4) Should the company use bank debt or add'l trade credit? Why.

Explanation / Answer

Purchases = $10,000,000;

terms = 3/5 net 60;

currently pays on Day 5 and takes discounts.

Forgoes discounts; additional credit = X

$10,000,000/365*55 days = $66,363,636.36

Nominal cost of trade credit =3 x 365 = 3.09% * 6.6364 = 20.52%.

Effective cost of trade credit = (1 + 3/97)365/55 - 1 = 1.2240- 1 = 22.40%.

Bank loan: 8%, interest paid monthly

EAR = (1 +0.8/12)12 - 1 = 1.1047 - 1 = 10.47%.

The effective cost of the bank loan is more than half the effective cost of the trade credit. Therefore , the bank loan should be used.

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