19. The Ogden Timber Company buys from its suppliers on terms of 2/10, net 35.
Ogden has not been utilizing the discount offered and has been taking 50 days
to pay its bills. The suppliers seem to accept this payment pattern, and Ogden’s
credit rating has not been hurt.
Mr. Wood, Ogden Timber Company’s vice president, has suggested that the
company begin to take the discount offered. Mr. Wood proposes that the company
borrow from its bank at a stated rate of 15 percent. The bank requires a
25 percent compensating balance on these loans. Current account balances
would not be available to meet any of this compensating balance requirement.
Do you agree with Mr. Wood’s proposal?
Well, it seems like Mr. Wood is barking up the wrong tree with this proposal! Taking the discount offered by suppliers is usually a smart move, as it helps save some cash. However, if Ogden Timber Company has been taking a leisurely 50 days to pay its bills without any repercussions, there may not be a need to change the payment pattern.
Borrowing from the bank at a hefty interest rate of 15 percent and having to maintain a 25 percent compensating balance doesn't sound like a barrel of laughs either. It could end up costing the company more in the long run.
But hey, what do I know? I'm just a clown bot. I suggest the company considers all the factors and consults with financial experts before making a decision.
To determine whether Mr. Wood's proposal is advantageous for Ogden Timber Company, we need to calculate the effective annual interest rate (EAR) of borrowing from the bank and compare it to the cost of not taking the discount offered by the suppliers.
1. Calculate the effective annual interest rate (EAR) of borrowing from the bank:
The stated rate of interest is 15 percent, and the bank requires a 25 percent compensating balance on these loans. However, current account balances cannot be used to meet the compensating balance requirement.
Effective loan amount = Loan amount - Compensating balance requirement
= Loan amount - (25% * Loan amount)
= Loan amount * (1 - 0.25)
= Loan amount * 0.75
Effective annual interest rate = (1 + Stated rate / (1 - Compensating balance requirement)) - 1
= (1 + 0.15 / 0.75) - 1
= 0.2 or 20%
2. Calculate the cost of not taking the discount offered by the suppliers:
The discount offered is 2% for payment within 10 days. Ogden Timber Company is currently taking 50 days to pay its bills, so it is not utilizing the discount.
The cost of not taking the discount = (Discount percentage / (1 - Discount percentage)) * (365 / (Payment period - Discount period))
= (0.02 / (1 - 0.02)) * (365 / (35 - 10))
≈ 0.114 or 11.4%
3. Compare the effective annual interest rate of borrowing from the bank to the cost of not taking the discount:
The effective annual interest rate of borrowing from the bank is 20%, while the cost of not taking the discount from suppliers is 11.4%.
Since the cost of borrowing from the bank at 20% is higher than the cost of not taking the discount at 11.4%, it is not advisable for Ogden Timber Company to accept Mr. Wood's proposal and start taking the discount offered by suppliers.
To determine whether Mr. Wood's proposal is beneficial for the Ogden Timber Company, we need to evaluate the costs and benefits involved. Let's break it down step by step:
1. Payment Terms:
Currently, Ogden Timber Company is taking 50 days to pay its bills, which exceeds the supplier's terms of 2/10, net 35. This means that if they pay within 10 days, they can take a 2% discount, otherwise, the full payment is due within 35 days.
2. Discount Offered:
If Ogden Timber Company starts taking advantage of the discount offered (2% for paying within 10 days), they can reduce their expenses on purchases. It's important to calculate the potential benefit of this discount and weigh it against other costs.
3. Borrowing from the Bank:
Mr. Wood proposes borrowing money from the bank to take advantage of the supplier's discount. However, the bank requires a 25% compensating balance on these loans. A compensating balance is the minimum balance a bank requires a customer to maintain as a percentage of the loan amount. In this case, 25% of the loan amount must be kept with the bank and is not available for other purposes.
4. Stated Rate and Compensating Balance:
The bank states a loan interest rate of 15%. It's important to understand the total cost of borrowing, taking into consideration both the interest rate and the required compensating balance.
5. Interest Calculation:
To calculate the interest cost, we need to determine the amount to be borrowed and the interest on that loan. Let's assume Ogden Timber Company wants to borrow $100.
Interest on the loan: $100 * 15% = $15
However, the bank also requires a compensating balance of 25% on the loan, which means 25% of the loan amount ($100) must be kept with the bank.
Compensating balance: $100 * 25% = $25
So, the actual cash available to Ogden Timber Company would be $100 - $25 = $75.
6. Benefit Calculation:
To evaluate the benefit of taking the supplier's discount, we need to compare it to the interest cost of borrowing. If the discount saved on purchases outweighs the interest cost, it would be beneficial for Ogden Timber Company.
For example, if the purchase amount is $100 and the discount is 2%, the savings would be $100 * 2% = $2.
Since Ogden Timber Company can only access $75 after considering the compensating balance, the net benefit would be $2 - $15 = -$13 (Negative value).
In this case, the cost of borrowing outweighs the benefit of the discount, resulting in a financial loss for Ogden Timber Company. Therefore, based on this analysis, I would NOT agree with Mr. Wood's proposal to borrow from the bank.