Bank loan to take cash discount The Reynolds Corporation buys from its suppliers

Question

Bank loan to take cash discount The Reynolds Corporation buys from its suppliers on terms of 2/10, net 55. Reynolds has not been utilizing the discounts offered and has been taking 55 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 14 percent. The bank requires a 20 percent compensating balance on these loans. Current account balances would not be available to meet any of this compensating balance requirement.

   Do you agree with Duke's proposal?

Explanation / Answer

Answer:

Currently Reynolds takes 55 days instead of 2% cash discount it means we can say that annual interest rate shall be = 2% * 365 /55 = 13.27%

So we can say that 55 days credit period financing currently cost the co. 13.27%

But if we use cash discount then the co. has to pay 14% interest on 98% hence cost shall be = 14*98% = 13.72%

The bank requires a 20 percent compensating balance hence the next cost shall be = 13.72% / (1-0.20) = 17.15%

Hence its not better to choose cash discount.

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