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Chapter 3: 22BP (page 251)

The Reynolds Corporation buys from its suppliers on terms of 3/17, net 45. Reynolds has not been utilizing the discounts offered and has been taking 45 days to pay its bills.

Mr. Duke, Reynolds Corporation vice president, has suggested that the company begin to take the discounts offered. Duke proposes that the company borrow from its bank at a stated rate of 16 percent. The bank requires a 27 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 Duke’s proposal?

Short Answer

Expert verified

The company should follow Duke’s proposal.

Step by step solution

01

Information provided in the question

Discount = 3%

Discount period = 17 days

Payment period =45 days

Interest rate = 16%

Compensating balance = 27%

02

Calculation of cost of not taking the discount

The cost of not taking the discount is 39.7%.

Costofnottakingdiscount=Discountpercentage100%-Discountpercentage×360Finalduedate-Discountperiod=3%97%×36045-17=39.7%

03

Calculation of cost of effective interest rate on loan

The effective interest rate is 21.91%.

Effectiveinterestrate=Interestrate1-Compensatingbalancerate=16%1-0.27=21.91%

04

Decision on which proposal to be selected

The cost of not taking the discount is 39.7% and the effective interest rate on the loan taken from the bank is 21.91%. The cost of borrowing is less than the cost of not taking the discount, so the corporation should borrow money and take advantage of the discount offered to them.

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