# Effective rate of interest

Neveready Flashlights, Inc needs $300,000 to take a Cash discount of 2/10, net 70. A banker will loan the money for 60 days at an interest cost of $5,500.

a) What is the effective rate on the bank loan?

b)How much would it cost (in percentage term) if the firm did not take the cash discount, but paid the bill in 70 days instead of 10 days?

c) Should the firm borrow the money to take the discount?

d) If the bankers requires a 20% compensating balance, how much must the firm borrow to end up with the $300,000?

e) What would be the effective interest rate in part d if the interest charge for 60 days were $6,850?. Should the firm borrow with the 20% compensating balance? ( The firms has no funds to count against the compensating balance requirement).

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#### Solution Preview

a) What is the effective rate on the bank loan?

Per period cost of loan=

=5,500/300,000= 1.833%

No of periods= =365/60= 6.08

Effective annual cost is

= [(1 + per period rate)^number of periods per year - 1] X 100

= [(1 + 0.01833)^6.08 - 1] X 100

= 11.68percent

b) How much would it cost (in percentage term) if the firm did not take the cash discount, but paid the bill in 70 days instead of 10 days?

No of periods= =365/60= 6.08

Per period cost of loan= ...

#### Solution Summary

Compares the rate of interest on a bank loan with the cost of not taking a cash discount.