The Reynolds Corporation buys from its suppliers on terms of 3/18, net 65. Reyno

Question

The Reynolds Corporation buys from its suppliers on terms of 3/18, net 65. Reynolds has not been utilizing the discounts offered and has been taking 65 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 18 percent. The bank requires a 28 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 360 days in a year. Round your intermediate calculations and final answers to 2 decimal places. Omit the "%" sign in your response.) Cost of not taking a cash discount % (b) Calculate the effective rate of interest if the company borrows from the bank. (Use 360 days in a year. Round your intermediate calculations and final answers to 2 decimal places. Omit the "%" sign in your response.) Effective rate % (c) Do you agree with Duke's proposal? No Yes

Explanation / Answer

Cost of not taking a cash = Discount % discount 100% - Disc.% Final due date - Discount period 2% 360 = = 2.04% 8 = 16.32% 98% (55 - 10) Effective rate of interest with a 20% compensating balance requirement: = Interest rate/(1 C) = 14%/(1 .2) = 14%/(.8) = 17.5% The effective cost of the loan, 17.5%, is more than the cost of passing up the discount, 16.32%. Reynolds Corporation should continue to pay in 55 days and pass up the discount.

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