Costs of Alternative Sources of Short-term Financing. On March 1, 20X1, National Corporation purchased $100,000 worth of inventory on credit with terms of 1/20, net/60. In the past, National has always followed the policy of making payment 1 month (30 days) after the goods are purchased.
A new member of National’s staff has indicated that the company she had previously worked for never passed up its cash discounts, and she wonders if that is not a sound policy. She has also pointed out to National that if it does not take advantage of the cash discount, it should wait the entire 60-day period to pay the full bill rather than paying within 30 days.
If National were to take advantage of the discount and pay the bill on March 20 rather than on March 30, the firm would have to borrow the necessary funds for the 10 extra days. National’s borrowing terms with a local bank are estimated to be at 81 2 percent (annual rate), with a 15 percent compensating balance for the term of the loan. Most members of National’s staff feel that it makes little sense to take out an 81 2 percent loan with a compensating balance of 15 percent in order to save 1 percent on its $100,000 by paying the account 10 days earlier than it had planned.
(a) Just in terms of true interest cost, would it be to National’s advantage to take the 1 percent discount by paying the bill 10 days earlier than usual if to do this it borrowed the necessary amount on the above-mentioned terms? (b) If National ordinarily paid 60 days after purchase (instead of 30 days); would the company benefit by taking the discount if it had to borrow the money on the above-mentioned terms? (c) Compare your answers to (a) and (b) and explain what makes the discount more (less) desirable under the conditions stated in (b) than in (a). (CMA, adapted.)