Lamar Lumber buys $8 million of materials (net of discounts) on terms of 3/5, ne
ID: 2662953 • Letter: L
Question
Lamar Lumber buys $8 million of materials (net of discounts) on terms of 3/5, net 60; and it currently pays after 5 days and takes discounts. Lamar plans to expand, which will require additional financing. If Lamar decides to forgo discounts, how much additional credit could it get and what would be the nominal and effective cost of that credit? If the company could get the funds from a bank at a rate of 10%, interest paid monthly, based on a 365-day, what would be the effective cost of the bank loan, and should Lamar use bank debt or additional trade credit? Explain.Explanation / Answer
Effective annual rate = EAR = (1+ iNom/m)^m - 1 By using terms of 3/5 net 60, it means if Lamar pays up within 5 days, he gets a discount of 3% else he can pay the full amount in 60 days. Here 3% of $8M = $240,000 Thus Lamar is paying ($8M- $240,000) = $7,760,000 within 5 days or paying an 'Interest" of $240,000 for (60-5) = 55 days for borrowing $7760,000 SO $240,000 borowwed on $7760,000, the Int rate is 240,000/7760,000 = 3.09%. Now we see from above that this int rate is for 55 days. So there are 365/55 = 6.64 such period in 365 days. So for 365 days, EAR will be (1+3.09%)^6.64 -1 = 22.39%........(a) If Bank Financng is used, Int rate is 10% pm. SO for one year, no of period is 12 So EAR for bank loan = (1+10%/12)^12 - 1 = 10.47%........(b) Looking at a & b above, it is obvious that Lamar should use Bank debt route.
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