Question

Quantitative Problem: Adams Manufacturing Inc. buys $8.1 million of materials (net of discounts) on terms of 2/10, net 50; and it currently pays after 10 days and takes the discounts. Adams plans to expand, which will require additional financing. If Adams decides to forgo discounts, how much additional credit could it obtain? Round your answer to the nearest cent. Do not round your intermediate calculations. Use 365 day in a year.

$__

What would be the nominal and effective cost of such a credit? Round your answer to 2 decimal places. Do not round intermediate calculations. Use 365 day in a year.

Nominal cost: __%

Effective cost: __%

If the company could receive the funds from a bank at a rate of 7.9%, interest paid monthly, based on a 365-day year, what would be the effective cost of the bank loan? Round your answer to 2 decimal places. Do not round intermediate calculations.

__%

Should Adams use bank debt or additional trade credit?

A. The bank loan should be used

B. Additional trade credit should be used

Answer 1

a). Additional Credit = np x [365 / (f - p)]

This is where:

• np is the net purchase
• f is the final due date
• p is the discount period

Additional Credit = $8,100,000 x [365 / (50 - 10)] = $73,912,500

b). Nominal Cost of Trade Credit = [365 / (f - p)] x [d / (1 - d)]

= [365 / (50 - 10)] x [0.02 / (1 - 0.02)] = 9.125 x 0.0204 = 18.62%

Effective Cost of Trade Credit = [1 + {365/(f - p)}]^{{d / (1 - d)}} - 1

= [1.09125]^2.04 - 1 = 1.1951 - 1 = 0.1951, or 19.51%

c). Effective Rate of Interest = [1 + (i / t)]^t - 1

This is where:

• i is the interest rate
• t is the term or number of periods

Effective Rate of Interest = [1 + (0.079/12)]¹² - 1 = 1.0819 - 1 = 0.0819, or 8.19%

d). Because the effective cost of the bank loan is less than half the effective cost of the trade credit then the bank loan should be used.