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Judy's Fashions, Inc. purchases supplies from a single supplier on terms of 1/10, net 20. Currently, Judy takes the discount, but she believes she could extend the payment to 40 days without any adverse effects if she decided not to take the discount. Judy needs an additional $50,000 to support an expansion of fixed assets. This amount could be raised by making greater use of trade credit or by arranging a bank loan. The banker has offered to loan the money at 12 percent discount interest. Additionally, the bank requires an average compensating balance of 20 percent of the loan amount. Judy already has a commercial checking account at this bank which could be counted toward the compensating balance, but the required compensating balance amount is twice the amount that Judy would otherwise keep in the account. Which of the following statements is most correct?

a. The cost of using additional trade credit is approximately 36 percent.

b. Considering only the explicit costs, Judy should finance the expansion with the bank loan.

c. The cost of expanding trade credit using the approximation formula is less than the cost of the bank loan. However, the true cost of the trade credit when compounding is considered is greater than the cost of the bank loan.

d. The effective cost of the bank loan is decreased from 17.65 percent to 15.38 percent because Judy would hold a cash balance of one-half the compensating balance amount even if the loan were not taken.

e. If Judy had transaction balances that exceeded the compensating balance requirement, the effective cost of the bank loan would be 12.00 percent.

Basic Finance, Finance

  • Category:- Basic Finance
  • Reference No.:- M944081

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