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Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250
Textbook Problem

COST OF TRADE CREDIT AND BANK LOAN Lancaster Lumber buys $8 million of materials (net of discounts) on terms of 3/5, net 55, and it currently pays on the 5th day and takes discounts. Lancaster plans to expand, which will require additional financing. If Lancaster decides to forgo discounts, how much additional credit could it obtain, and what would be the nominal and effective cost of that credit? If the company could get the funds from a bank at a rate of 9%, interest paid monthly, based on a 365-day year, what would be the effective cost of the bank loan? Should Lancaster use bank debt or additional trade credit? Explain.

Summary Introduction

To determine: The additional credit, the nominal and effective cost of credit, the effective cost of the bank loan and what should be used by the bank debt or additional trade credit.

Introduction:

Cost of Trade Credit:

The trade credit refers to the credit sale. This credit  owes money for the seller, so it is treated as accounts receivable by the seller and this money is accounted as accounts payable by the buyer.

Explanation

Given information:

The materials on terms are worth $8 million.

It currently pays on the 5th day.

Discount rate is 3%.

The bank rate is 9% paid monthly based on 365 days a year.

Calculation of the additional credit:

The formula to calculate the additional credit is,

Additionalcredit=MaterialworthDaysinayear×Numberofdays

Substitute $8 million for material worth and 50 days for a number of days (refer working note) in the above formula.

Additionalcredit=$8,000,000365×50days=$1,095,890.41

The additional credit is $1,095,890.41.

Calculation of the nominal cost of credit:

The formula to calculate the nominal annual cost of credit is,

Nominalannualcostofcredit=(Discount%100Discount%)×(365daysNumberofdays)

Substitute 3% for the discount percent and 50 days for the number of days in the above formula.

Nominalannualcostofcredit=(3%1003%)×(365days50days)=(3%97%)×(36550)=0.2258or22.58%

The nominal annual cost of credit is 22.58%.

Calculation of the effective cost of credit:

The formula to calculate the effective cost of credit,

Effectivecostoftradecredit=(1+Discount%100Discount%)(365Numberofdays)1

Substitute 3% for discount percent and 50 for the number of days in the above formula

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