The Reynolds Corporation buys from its suppliers on terms of 2/11, net 60. Reyno
ID: 2690890 • Letter: T
Question
The Reynolds Corporation buys from its suppliers on terms of 2/11, net 60. Reynolds has not been utilizing the discounts offered and has been taking 60 days to pay its bills. Mr. Duke, Reynolds Corporation vice president, has suggested that the company begin to take the discounts offered. Duke proposes that the company borrow from its bank at a stated rate of 16 percent. The bank requires a 24 percent compensating balance on these loans. Current account balances would not be available to meet any of this compensating balance requirement.Explanation / Answer
The Reynolds Corporation buys from its suppliers on terms of 2/10, net 55. Reynolds has not been utilizing the discounts offered and has been taking 55 days to pay its bills. Mr. Duke, Reynolds Corporation vice president, has suggested that the company begin to take the discounts offered. Duke proposes that the company borrow from its bank at a stated rate of 14 percent.
The bank requires a 20 percent compensating balance on these loans. Current account balances would not be available to meet any of this compensating balance requirement. Do you agree with Duke's proposal?
Reynolds Corporation Effective rate of interest with a 20% compensating balance requirement: = Interest rate/(1 C) = 14%/(1 .2) = 14%/(.8) = 17.5%
The effective cost of the loan, 17.5%, is more than the cost of passing up the discount, 16.32%. Reynolds Corporation should continue to pay in 55 days and pass up the discount.
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