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 $11,500 with terms of 2.4/10 Net 40, so the supplier will give them a 2.4 % discount if they pay by today (when the discount period expires). Alternatively, they can pay the full $11,500 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 $11,500 in one month.

Alternative B: Borrow the money needed to pay its supplier today from Bank A, which has offered a one-month loan at an APR of 11.9%. The bank will require a (no-interest) compensating balance of 4.9 %of the face value of the loan and will charge a $100 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 14.8%. The loan has a 1.2% loan origination fee, which again H2M will need to borrow to cover.

The effective annual cost is ______ (alternative A, B, and C)

Answer 1

Alternative A-Delay the payment

Effective cost(monthly) = discount forgone=2.4%

Effective cost(annually)=2.4*12=28.8%

Alternative B -borrow form Bank A

Total amount to be borrowed=(fees + $11500)/(1-compensating balance)

= (100+$11500)/(1-0.0409)

= 11600/0.9591

=$12094.672

Interest cost for one month =$12094.672*0.119*(1/12)

=$119.93

Effective cost (monthly)= interest/payment to be made to dealer=$119.93/11500

=0.01043 or 1.43%

Effective cost (annually)=1.043*12=12.516%

Alternative C -Borrow from bank B

Total amount to be borrowed=fees +$11500

= 138+11500

=$11638

Interest cost for one month =$11638*0.148*(1/12)

=$143.5353

Effective cost(monthly) = interest/payment to be made to dealer=$143.5353/11500

=0.01248or 1.248%

Effective cost(annually)=1.248*12=14.976%

Decision-The effective annual cost is 12.516 In Alternative B.