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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鈥檚 proposal?

Short Answer

Expert verified

The company should follow Duke鈥檚 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脳360Finalduedate-Discountperiod=3%97%脳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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Most popular questions from this chapter

Henderson Office Supply is considering a more liberal credit policy to increase sales, but expects that 9 percent of the new accounts will be uncollectible. Collection costs are 6 percent of new sales, production and selling costs are 74 percent, and accounts receivable turnover is four times. Assume income taxes of 20 percent and an increase in sales of $65,000. No other asset build-up will be required to service the new accounts.

c. Should Henderson liberalize credit if a 16 percent after-tax return on investment is required?

Bombs Away Video Games Corporation has forecasted the following monthly sales:

January

\(100,000

February

\)93,000

March

\(25,000

April

\)25,000

May

\(20,000

June

\)35,000

July

\(45,000

August

\)45,000

September

\(55,000

October

\)85,000

November

\(105,000

December

\)123,000

Total annual sales

\(756,000

Bombs Away Video Games sells the popular Strafe and Capture video game. It sells for \)5 per unit and costs \(2 per unit to produce. A level production policy is followed. Each month鈥檚 production is equal to annual sales (in units) divided by 12.

Of each month鈥檚 sales, 30 percent are for cash and 70 percent are on account. All accounts receivable are collected in the month after the sale is made.

c. Determine a cash payments schedule for January through December. The production costs of \)2 per unit are paid for in the month in which they occur. Other cash payments, besides those for production costs, are $45,000 per month.

What are the advantages of commercial paper in comparison with bank borrowing at the prime rate? What is a disadvantage?

Bombs Away Video Games Corporation has forecasted the following monthly sales:

January

\(100,000

February

\)93,000

March

\(25,000

April

\)25,000

May

\(20,000

June

\)35,000

July

\(45,000

August

\)45,000

September

\(55,000

October

\)85,000

November

\(105,000

December

\)123,000

Total annual sales

\(756,000

Bombs Away Video Games sells the popular Strafe and Capture video games. It sells for \)5 per unit and costs $2 per unit to produce. A level production policy is followed. Each month鈥檚 production is equal to annual sales (in units) divided by 12.

Of each month鈥檚 sales, 30 percent are for cash and 70 percent are on account. All accounts receivable are collected in the month after the sale is made.

a. Construct a monthly production and inventory schedule in units. Beginning inventory in January is 25,000 units. (Note: To do part a, you should work in terms of units of production and units of sales.)

Lear Inc. has \(840,000 in current assets, \)370,000 of which are considered permanent current assets. In addition, the firm has \(640,000 invested in fixed assets.

a. Lear wishes to finance all fixed assets and half of its permanent current assets with long-term financing costing 8 percent. The balance will be financed with short-term financing, which currently costs 7 percent. Lear鈥檚 earnings before interest and taxes are \)240,000. Determine Lear鈥檚 earnings after taxes under this financing plan. The tax rate is 30 percent.
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