Professors Note: Your answer is close but incorrect. Please review "calculating the effective cost of short term credit" in your text. You need to make sure that the note amount is the NET amount (what Worthington actually receives after costs/int).
Please edit this essay based on the above note:
Worthington, Inc. is planning to issue $7,500,000 in 120-day maturity notes carrying a rate of 11 percent per year. Worthington's commercial paper will be placed at a cost of $35,000. What is the effective cost of credit to Worthington?
The effective cost of credit is respectively determined through the cost of acquiring funds which are used within specific investments. Within this scenario, Worthington, Inc. will be issuing $7,500,000 in 120-day maturity notes, which will carry a rate of 11% per year. What this means is that Worthington, Inc. has taken on borrowed funds and has now committed themselves to pay a designated sum which will be due after 120 days from when the sum was borrowed. Because nothing comes for free, and there is interest on everything, Worthington, Inc. had to promise an 11% rate on the borrowed funds in return for the lenders money. Unfortunately for Worthington, Inc. this means that they end up repaying much more than it had originally borrowed.
On top of the interest that will be paid out, Worthington, Inc. will also incur additional expenses because they are employing a borrowing mechanism through the giving of notes. The short term cost of the notes is $35,000, which entails the cost of the actual transaction, insurance, and applicable taxes.
Within the scenario of Worthington, Inc., the maturity period of the notes are 120 days. Assuming 360 days in a year, 120 days is 1/3 of that year (360 days /3= 120) leaving the annual interest rate for the bond at 11% payable in thirds. This would be the same as is a 3.66667% interest on the whole amount. Ultimately, the credit interest is costing $275,000 which is $7,500,000* (120/360 * 11%) + $35,000. When you add the interest cost of $275,000 to the $35,000 commercial paper cost, the effective cost of credit to Worthington, Inc. totals $310,000 ($275,000 + $35,000). The breakdown is as follows:
- Assumed days in a year = 360
- Interest to pay for 120 days = $7,500,000 * 11% * 120/360 = $275,000
- Cost of commercial paper = $35,000
- Total cost taken on for 120 period = $275,000+$35,000 = $310,000
- Assuming the year has 360 days, the answer is: $310,000/$7,500,000 = 4.1333%
- Since the rate is not expressed on an annual basis, it must be annualized: 4.1333% × 3 = 12.40%