Lamar Lumber buys $8 million of materials (net of discounts) on terms of 3/5, ne

Question

Lamar Lumber buys $8 million of materials (net of discounts) on terms of 3/5, net 55; 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 11%, 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.
%

Explanation / Answer

Part A)

If the discount is not availed by the Lamar, the additional credit that can be obtained can be calculated with the use of following formula:

Additional Credit = Value of Materials*(Credit Outstanding Period - Discount Period)/365 days

______________

Here, Credit Outstanding Period = 55 and Discount Period = 5

Using these values in the above formula, we get,

Additional Credit = 8000000*(55 - 5)/365 = $1,095,890.41

_____________

Part B)

Nominal cost of trade credit can be calculated with the use of discount percentage and credit outstanding and discount period. The formula for calculating nominal cost of trade credit is:

Nominal Cost of Trade Credit = [(Discount %)/(1-Discount%)]*[365/(Credit Outstanding Period - Discount Period)]

_____________

Using the information provided in the question, we get,

Nominal Cost of Trade Credit = [(3%/(100-3%)]*[(365/(55-5)] = 22.58%

_____________

Part C)

To calculate effective cost of trade credit, we require cost per period and total number of periods. Relevant formulas are:

Cost Per Period = Discount %/(1- Discount %)

Number of Periods = 365//(Credit Outstanding Period - Discount Period)

Effective Cost of Credit = (1+Cost Per Period)^Number of Periods - 1

_____________

Using the information provided in the question, we get,

Cost Per Period = 3%/(1-3%) = 3.09%

Number of Periods = 365/(55-5) = 7.3

Effective Cost of Credit = (1+3.09%)^(7.3)-1 = 24.90%

_____________

Part D)

The effective cost of bank loan can be calculated with the use of monthly bank interest rate. The formula for calculating effective cost of bank loan is:

Effective Cost of Bank Loan = (1+Bank Rate/n)^n - 1 where n is the number of months

_____________

Using the information provided in the question, we get,

Effective Cost of Bank Loan = (1+11%/12)^12 - 1 = 11.57%

Lamar should opt for bank loan, as its cost is less than the effective cost of additional trade credit.

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