Question

There are three alternatives to increase each financing alternative is for a full year.) (1) Forego cash discounts with the terms of 2/10/net 40. (2) Borrow the money at 7 percent from the bank on a regular basis. This bank 8-2 net working capital by $10,000.(Assume loan requires a minimum compensating balance of 20 percent. (3) Sell commercial paper at 8 percent. The underwriting fees of the issue are 2 percent of the face value. Calculate the effective annual interest rate of each alternative.

Answer 1

1) 2/10 net 40 can be defined as 2% discount will be given if the loan is repaid in 10 days otherwise the full amount should be payable in 40 days.

• Discount = 2%

Given: if the amount is paid within 10 days, there will be 2% discount. Hence, 2% is charged for a 30 day period. For 1 year (365 days), the effective cost will be:

(365/30)∗0.02 =0.24333

Effective Cost = 24.33%

2) Calculation of effective interest on borrowings with minimum compensation balance:

• Subtract the compensatory balance from the total principal to calculate the available balance. Total borrowings is for $10,000 and the compensatory balance is 20% (i.e., $2,000), your available balance is $8,000.
• Divide the nominal interest due by the available principal to calculate the effective interest rate of your compensatory balance installment borrowings.
• interest rate on a compensatory balance borrowings has an interest rate of 7 percent, a principal of $10,000, and a compensatory balance of $2,000.

Effective interest rate = $700/($10,000 - $2,000) = $700/$8,000 = 0.0875 = 8.75%

3)

1. Book value of commercial paper = $10,000
2. Issue price of commercial paper = ($10,000 - 8% discount) = $9,200
3. Time = 365 days
4. Fees charged = $200

.The effective rate is higher than the stated interest rate because of the compensatory balance.