Brand advertising is offered a 3/10 net 40 trade discount by its supplier. In the past Brand has been able to get away with paying for supplies on credit in 60days. since it doesnt have money on hand to take advantage of discount, it tries to negotiate a loan with portland state bank. The amount of 375000 with 15% compensating balance and 5500 interest charge has been negotiated for the month of May. Brand already maintains a 16250 balance at the bank. Compute the effective rate of interest on the loan, and the cost of not taking the discount. Should Brand take advantage of the cash discount?
To compute the effective rate of interest on the loan, we need to consider the compensating balance requirement and the interest charge.
1. Calculating the Effective Rate of Interest:
a. Start by determining the total loan amount, which includes the compensating balance. Since the compensating balance is 15%, the total loan can be calculated as:
Loan amount = $375,000 / (1 - 15%) = $375,000 / (1 - 0.15) = $375,000 / 0.85 = $441,176.47
b. Next, calculate the interest charge for the month. The interest charge is given as $5,500.
c. Now we can calculate the effective rate of interest for the loan. The formula for calculating the effective rate of interest is:
Effective Rate of Interest = (Interest Charge / Loan Amount) x (12 / Number of Months)
Given:
Interest Charge = $5,500
Loan Amount = $441,176.47
Number of Months = 1 (since it is for the month of May)
Effective Rate of Interest = ($5,500 / $441,176.47) x (12 / 1)
= 0.01247 x 12
= 0.14964 or 14.964%
Therefore, the effective rate of interest on the loan is approximately 14.964%.
2. Now, let's calculate the cost of not taking the discount:
a. The trade discount offered by the supplier is 3/10 net 40. This means, if Brand pays within 10 days, they can enjoy a 3% discount. Otherwise, the full amount needs to be paid within 40 days.
b. Since Brand normally pays within 60 days, they would not be eligible for the discount.
c. The cost of not taking the discount can be calculated by multiplying the total amount ($375,000) by the discount rate (3%):
Cost of not taking the discount = $375,000 x 3% = $375,000 x 0.03 = $11,250.
Therefore, the cost of not taking the discount would be $11,250.
3. Finally, whether Brand should take advantage of the cash discount depends on comparing the cost of not taking the discount ($11,250) with the effective rate of interest on the loan (approximately 14.964%).
As the effective rate of interest is significantly higher than the cost of not taking the discount, it would be more beneficial for Brand to take advantage of the cash discount. By paying early, they can reduce their cost by $11,250 compared to the interest charges on the loan.