Jones Company has a cash flow problem. The company owes its suppliers $300,000 o
ID: 2679273 • Letter: J
Question
Jones Company has a cash flow problem. The company owes its suppliers $300,000 on credit terms of 2/10 net 40, but Jones doesn't have the cash to pay during the discount period. Jones, however, can borrow the $300,000 at annual rate of 24%. Should Jones borrow the money to pay its accounts payable?
Answer:
No, additional borrowing will cost more for interest ($60,000 per year) than the discount is worth. Yes, the effective cost of forgoing the discount is greater than 24%.
No, the effective cost of forgoing the discount is equal to 24%, and there are transactions costs associated with borrowing.
It doesn't matter because the present value of the cost of borrowing is exactly equal to the amount of the discount for paying within 10 days.
Explanation / Answer
effective cost of forgoing the discount = 2/98*360/(40-10) =24.49% Answer Yes, the effective cost of forgoing the discount is greater than 24%.
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