Question

Lancaster Lumber buys $8 million of materials (net of discounts) on terms of 3/5, net 80; and it currently pays on the 5th day and takes discounts. Lancaster plans to expand, which will require additional financing. Assume 365 days in year for your calculations.

a. If Lancaster decides to forgo discounts, how much additional credit could it obtain? Write out your answer completely. For example, 5 million should be entered as 5,000,000. Round your answer to the nearest cent.

b. What would be the nominal cost of that credit? Do not round intermediate calculations. Round your answer to two decimal places.

c. What would be the effective cost of that credit? Do not round intermediate calculations. Round your answer to two decimal places.

d. If the company could get the funds from a bank at a rate of 7%, interest paid monthly, based on a 365-day year, what would be the effective cost of the bank loan? Do not round intermediate calculations. Round your answer to two decimal places.

e. Should Lancaster use bank debt or additional trade credit?

Answer 1

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Answer:

Purchases = $8,000,000

Term = 3/5, net 80

Currently pays on Day 5 and takes discount.

Answer 1.

Additional Credit = $8,000,000/365*75

Additional Credit = $1,643,835.6

Answer 2.

Nominal Cost of Trade Credit = 0.03/0.97 * 365/75

Nominal Cost of Trade Credit = 0.1505

Nominal Cost of Trade Credit = 15.05%

Answer 3.

Effective Rate of Trade Credit = (1+0.03/0.97)^(365/75) - 1

Effective Rate of Trade Credit = 15.98%

Answer 4.

7% interest paid monthly

EAR = (1+0.7/12)^(12) – 1

EAR = 9.75%

Bank Loan because the effective cost of the bank loan is less than half the effective cost of the trade credit, the bank loan should be used.