Judy's Fashions Inc Purchases Supplies From A Single Supplie

Judys Fashions Inc Purchases Supplies From A Single Supplier On Ter

Judy's Fashions, Inc. purchases supplies from a single supplier on terms of 1/10, net 20. Currently, Judy takes the discount, but she believes she could extend the payment to 40 days without any adverse effects if she decided not to take the discount. Judy needs an additional $50,000 to support an expansion in fixed assets. This amount could be raised by making greater use of trade credit or by arranging a bank loan. The banker has offered to loan the money at 12% discount interest. Additionally, the bank requires an average compensating balance of 20 percent of the loan amount. Judy already has a commercial checking account at the bank which could be counted toward the compensating balance, but the required compensating balance amount is twice the amount that Judy would otherwise keep in the account. Which of the following statements is most correct? a. The cost of using additional trade credit is approximately 36 percent. b. Considering only the explicit costs, Judy should finance the expansion with the bank loan. c. The cost of expanding trade credit using the approximation formula is less than the cost of the bank loan. However, the true cost of the trade credit when compounding is considered is greater than the cost of the bank loan. d. The effective cost of the bank loan is decreased from 17.65 percent to 15.38 percent because Judy would hold a cash balance of one-half the compensating balance amount even if the loan were not taken. e. If Judy had transaction balances that exceed the compensating balance requirement, the effective cost of the bank loan would be 12.00%.

Paper For Above instruction

Judy's Fashions Inc faces a critical financial decision regarding the most cost-effective way to finance an expansion through additional working capital. With options including trade credit and bank financing, understanding the costs associated with each alternative is vital for optimal decision-making. This analysis explores the implications of deferring payments, utilizing trade credit, and engaging bank loans, with particular attention to the effective costs considering implicit and explicit factors such as discounts, interest rates, compensating balances, and compound interest effects.

Initially, Judy benefits from early payment discounts when purchasing supplies—terms of 1/10, net 20 imply a 1% discount if paid within ten days and the full amount due within twenty days. While advantageous, she considers extending the payment window to 40 days, which exceeds the net period, thus sacrificing the discount but potentially alleviating cash flow pressures. If Judy chooses to forgo early discounts, she effectively delays her cash outflow, but this comes with implicit costs, notably the opportunity cost of not utilizing the discount earlier.

In comparison, bank financing offers an alternative, where Judy could borrow $50,000 at a 12% discount interest rate. However, the bank's requirement of a 20% compensating balance complicates the effective interest calculation. The compensating balance is essentially a cash reserve that Judy must maintain in her account as collateral or reserve requirement, which reduces the amount available for use but increases the effective cost of borrowing. Moreover, the fact that Judy’s checking account balance can count toward this compensating balance, but the required amount is twice what she would normally keep, influences the analysis of the total cost.

Analyzing the explicit costs, the bank loan's nominal interest rate of 12% appears straightforward; however, the actual cost when considering the compensating balance requirement is higher. The effective interest rate on the loan can be calculated considering the reserve requirement. Since the bank demands an equilibrium balancing of 20% of the loan amount as a compensating balance, Judy effectively receives only 80% of the loan amount available for use. The effective interest rate resultant from the discount interest and the compensating balance must be adjusted accordingly.

On the other hand, the trade credit alternative involves assessing the cost of extending payments from 20 days to 40 days. Using the approximation formula for the cost of trade credit, which considers the additional days of credit and the discounts forgone, one can estimate the implicit cost. This calculation suggests that deferring payment by an additional 20 days, without taking the discount, incurs a cost that might be less than the bank loan's effective rate, provided the compounding effects are properly considered.

When considering the implications of compounding, the true cost of trade credit can be higher than the initial approximation suggests because the forgone discounts and delayed payments are subject to compound interest calculations over the extended period. An accurate assessment involves estimating the annualized cost of trade credit, recognizing that the effective rate may surpass the bank's interest rate, especially when factoring in the opportunity costs associated with delayed payments.

The statement options involve intricate comparisons of these costs. Notably, option c correctly indicates that the approximate formula may underestimate the true compound interest cost of trade credit. Furthermore, it aligns with the analysis that the effective cost, when considering compounding, exceeds the explicit cost simplicity, and therefore, the true expense of extending trade credit in this scenario is higher than the comparable bank loan interest rate.

Option d discusses how holding a cash balance that partially fulfills the compensating balance reduces the effective cost of the bank loan from 17.65% to 15.38%. This is consistent with financial theory, which states that cash balances can reduce the effective interest rate on a borrowing facility by offsetting the need for holding higher reserves. The fact that the cash balance held is half the compensating balance further explains the reduction in effective interest rates, illustrating how liquidity management can influence borrowing costs.

In conclusion, the comparative analysis reveals that, while bank loans offer the simplicity of explicit costs at 12%, the combined implicit costs related to compensating balances and the effects of interest compounding may tilt preferences toward the alternative of extending trade credit if the true costs are considered. Given the detailed calculations and financial principles involved, the most accurate choice aligns with statement c, acknowledging that the approximate trade credit cost underestimates the true, compounded cost, which is higher than the bank's interest rate.

References

• Brigham, E. F., & Houston, J. F. (2019). Fundamentals of Financial Management. Cengage Learning.
• Ross, S. A., Westerfield, R., & Jordan, B. D. (2018). Fundamentals of Corporate Finance. McGraw-Hill Education.
• Gitman, L. J. (2015). Principles of Managerial Finance. Pearson Education.
• Van Horne, J. C., & Wachowicz, J. M. (2017). Fundamentals of Financial Management. Pearson.
• Higgins, R. C. (2012). Analysis for Financial Management. McGraw-Hill Education.
• Brealey, R. A., Myers, S. C., & Allen, F. (2020). Principles of Corporate Finance. McGraw-Hill Education.
• Damodaran, A. (2015). Applied Corporate Finance. Wiley Finance.
• Ross, S. A., & Westerfield, R. (2020). Corporate Finance. McGraw-Hill Education.
• Jorion, P. (2010). Value at Risk: The New Benchmark for Managing Financial Risk. McGraw-Hill.
• Fabozzi, F. J., & Peterson Drake, P. (2014). The Basics of Finance: An Introductory Text. John Wiley & Sons.