Simple Simon's Bakery purchases supplies on terms of 1.5/10, net 30.
If Simple Simon's chooses to take the discount offered, it must obtain a bank loan to meet its short-term financing needs. A local bank has quoted Simple Simon's owner an interest rate of 10.8 % on borrowed funds.
Should Simple Simon's enter the loan agreement with the bank and begin taking the discount? (Hint: Use 365 days for a year.)
Let us first find effective annual cost of trade credit
effective annual cost of trade credit = [1+Discount % /(1- discount %)]365/(Discount period) - 1
=[ 1+ 1.5%/(1-1.5%)]365/(30-10) - 1
=[ 1 + 0.015/0.985]365/20 - 1
=[ 1 + 0.015228]18.25 - 1
=1.01522818.25-1
=1.3176 -1
=0.3176
=31.76%
And bank loan = 10.8%
Since bank loan is cheaper than effective annual cost of trade credit, Simple Simon's enter the loan agreement with the bank and begin taking the discount
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