Question

A firm has the following choices to finance its inventory purchase:

•Credit terms of 3/25 net 45 EOM

•A single payment note with $300,000 principal and a 5.75% annual interest rate payable in 45 days

•A $300,000 loan with a 10% compensating balance requirement and 4.85% annual interest rate payable in 45 days (no money is on deposit with the lender)

•Selling $300,000 in commercial paper, that will be repaid in 45 days, for $297,500

1.Calculate the cost of not taking the discount.

2.Calculate the annualized cost of the (a) single payment note and (b) the loan with the compensating balance .

3.Calculate the annualized cost of issuing commercial paper.

4.Of the available options, how should the firm finance its inventory purchase? Should it take the discount or not? If it does, how should it finance the purchase? Support your answer.

Answer 1

1) If discount is not taken 3% discount amount cant be availed and payment has to be made in 20 days

Cost of not taking discount =3% on 97% = 3%/0.97 or 3.09% in 20 days

So, annualised cost = 1.0309^(360/20) -1 =73.02%

2) cost of Single note for 45 days - 5.75%* 45/360 =0.007188

So, Annualised cost =1.007188^(360/45)-1 =5.90%

Cost of loan with compensating balance for 45 days = 4.85%/0.9 * 45/360=0.006736

So, Annualised cost =1.006736^(360/45)-1 =5.52%

3) ($300000-$297500) = $2500 interest is paid in 45 days on a principal of $297500

So, cost for 45 days = 2500/297500 =0.008403

So, Annualised cost =1.008403^(360/45)-1 =6.92%

4) As the least cost option is the loan with compensating balance, the firm should finance its purchase through the loan with compensating balance. It should take the discount , as the cost of not taking discount is quite high.