The company has a cash flow problem. They owe their suppliers $100,000 on credit
ID: 2660831 • Letter: T
Question
The company has a cash flow problem. They owe their suppliers $100,000 on credit terms of 2/10 net 40, nut don't have the cash to pay during the discount period. They can however, borrow the $100,000 at an annual rate of 20%. Should they borrow the money to pay its accounts payable?
a. No, the 18% annual rate is much greater than the 2% discount.
b. No, additional borrowing will cost more for interest than the discount is worth.
c. Yes, the effective cost of foregoing the discount is greater than 20%.
d. It doesn't matter, because the cost of borrowing is $2,000 and the discount is $2,000, so the company ends up in the same position either way.
Explanation / Answer
If payment is made within 10 days we have to give discount of 2%
Therefore, discount = 100000*2%
= $2000
10 days cost is 2000
365 days cost will be (365*2000)/10 = $73000
If we borrow then we have to pay interest of 100000*20% = $20000
Therefore we should borrow.
Answer :- c. Yes, the effective cost of foregoing the discount is greater than 20