Hand-to-Mouth (H2M) is currently cash-constrained, and must make a decision abou

Question

Hand-to-Mouth (H2M) is currently cash-constrained, and must make a decision about whether to delay paying one of its suppliers, or take out a loan. They owe the supplier $12.500 with terms of 2/ 10 Net 40, so the supplier will give them a 2% discount if they pay by today (when the discount period expires). Alternatively, they can pay the full $12,500 in one month when the invoice is due. H2M is considering three options: Alternative A: Forgo the discount on its trade credit agreement, wait and pay the full $12,500 in one month. 12.3%. The bank will require a (no-interest) compensating balance of 52% of the face value of the loan and will charge a $95 loan origination fee. Because H2M has no cash, it will need to borrow the funds to cover these additional amounts as well. Alternative C: Borrow the money needed to pay its supplier today from Bank B, which has offered a one-month loan at an APR of 15%. The loan has a 1.5% loan origination fee, which again H2M will need to borrow to cover Alternative A The effective annual cost is Alternative B: The effective annual rate is Alternative C: The effective annual rate is (Select the best choice below.) 96. (Round to two decimal places.) %, (Round to two decimal places.) %. (Round to two decimal places.) A. Alternative B, with the lowest effective annual rate, is the best option for Hand-to-Mouth. O B. Alternative A, with the lowest effective annual rate, is the best option for Hand-to-Mouth. O C. Alternative C, with the lowest effective annual rate, is the best option for Hand-to-Mouth. O D. All the alternatives are equivalent.

Explanation / Answer

Alternative A

Discount = 12500*2% = 250

today payment = 12500 - 250 = 12250

duration 30 days (40-10)

Monthly rate = 250 / 12250 = 2.04%

EAR = (1+2.04%)12 - 1 = 27.43%

Alternative B

Amount to borrow = 12250*(1+5.2%) + 95 = 12982

Pay after month = 12982*(1+12.3%/12) = 13115.07

Monthly rate = 133.07 / 12982 = 1.03%

EAR = (1+1.03%)12 - 1 = 13.02%

Alternative C

Amount to borrow = 12250*(1+1.5%) = 12433.75

Pay after month = 12433.75*(1+15%/12) = 12589.17

Monthly rate = 155.42 / 12433.75 = 1.25%

EAR = (1+1.25%)12 - 1 = 16.08%

Option 1, Alternative B is better with lower EAR

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