Question

1. A firm’s current working capital needs amount to $1,000,000. Their supplier grants credit terms of 2/10, net 35. The manager believes that funds will not be available to take advantage of discount. He she believes that there is even a possibility that he/she may not have funds until 25 days past the net date.

A very friendly banker has offered to lend the firm funds at a rate of 15% with a 10% compensating balances. Should he/she borrow the funds and take the discount or should she/he pay when funds become available?

Answer 1

Here banker has offered to lend the firm funds at a rate of 15% with a 10% compensating balances.

Actual Borrowing Rate = Offered Rate / ( 1 - compensating balances Requirement)

= 15% / ( 1 - 10%)

= 15% / 90%

= 16.67%

Cost of not taking the Cash Discount =  

credit terms of 2/10, net 35

Discount = 2% = 0.02

Effective Days = 35 - 10 = 25 Days

Cost of not taking the Cash Discount =

= 0.29795 = 29.795%

Since Cost of Not taking discount is higher than actual borrowing rate ( 16.67%)

Firm should avail cash discount by borrowing.