Can anyone explain to me how to use this formula?
Cost of failing to
take a cash discount
Disc
�
ount percent
100 percent Discount percent
3
�
�
60
Final due date � Discount period
I am trying to calculate Assume the proceeds from the loan with the compensating balance requirement will be used to take cash discounts. Disregard part b about installment payments. and us the loan costs from part a. If the terms of the cash discount are 2/10, net 60, should the firm borrow the funds to take the discount? I cannot understand how I am supposed to do this. The figures I am using come from the following:
The Watson Corporation is negotiating a loan from PNC Bank. The company needs to borrow $300,000.
The bank offers a rate of 7% with a 30% compensating balance requirement, or as an alternative, 10% with additional fees of $4,700 to cover the services the bank is providing. In either case, the rate on the loan is floating (changes as the prime interest rate changes), and the loan would be for one year
To determine whether the firm should borrow the funds to take the cash discount, you need to calculate the cost of not taking the discount and compare it to the cost of borrowing the funds.
Here's how you can calculate it step by step:
1. Find the cost of not taking the cash discount:
- Start by finding the net amount due if the discount is not taken. The terms "2/10, net 60" mean that there is a 2% cash discount if paid within 10 days, and the full payment is due within 60 days. So, for the remaining 50 days (60 - 10), the full amount needs to be paid without any discount.
- Calculate the cost of not taking the discount by finding the difference between the amount due with the discount and the full amount due. This difference is the cost of not taking the cash discount.
2. Calculate the cost of borrowing the funds:
- If the company decides to borrow the funds, they need to compare the two loan options offered by PNC Bank.
- For the 7% rate with a 30% compensating balance requirement, calculate the amount of compensating balance required based on the $300,000 loan amount. Subtract this amount from the loan amount to determine the net proceeds from the loan.
- Calculate the interest expense by multiplying the net proceeds by the interest rate of 7%.
- If the company chooses the alternative option with a 10% rate and additional fees of $4,700, add these fees to the interest expense calculated in the previous step.
3. Compare the two costs:
- Compare the cost of not taking the cash discount (from step 1) to the cost of borrowing the funds (from step 2).
- If the cost of not taking the discount is higher than the cost of borrowing the funds, then it would be financially advantageous for the firm to borrow the funds and take the cash discount.
Please note that the specific calculations and figures mentioned in the question are not provided, so you would need to input the actual figures to arrive at the final decision.