Cost of Trade Credit and Bank Loan PLEASE ROUND CORRECTLY AND FOLLOW THE DIRECTI
ID: 2768040 • Letter: C
Question
Cost of Trade Credit and Bank Loan PLEASE ROUND CORRECTLY AND FOLLOW THE DIRECTIONS IN THE PROBLEM THANKS
Lamar Lumber buys $8 million of materials (net of discounts) on terms of 3/5, net 50; and it currently pays after 5 days and takes discounts. Lamar plans to expand, which will require additional financing. Assume 365 days in year for your calculations.
If Lamar decides to forgo discounts, how much additional credit could it obtain? Write out your answer completely. For example, 5 million should be entered as 5,000,000. Round your answer to the nearest cent.
$
What would be the nominal cost of that credit? Round your answer to two decimal places.
%
What would be the effective cost of that credit? Round your answer to two decimal places.
%
If the company could get the funds from a bank at a rate of 8%, interest paid monthly, based on a 365-day year, what would be the effective cost of the bank loan? Round your answer to two decimal places.
%
Should Lamar use bank debt or additional trade credit?
Explanation / Answer
Answer: Purchases = $8,000,000;
terms = 3/5 net 50;
currently pays on Day 5 and takes discounts.
Forgoes discounts; additional credit = X
$8,000,000/365*45 days = $986301.37
Nominal cost of trade credit =3/97x 365/45 = 3.09% * 8.11111 = 25.06%.
Effective cost of trade credit = (1 + 3/97)365/45 - 1 = 1.2240- 1 = 28.03%.
Bank loan: 8%, interest paid monthly
EAR = (1 +0.08/12)12 - 1 = 8.30%.
The effective cost of the bank loan is more than half the effective cost of the trade credit. Therefore , the bank loan should be used.