Chapter Part 5 (TVM): Time Value of Money Module

On March 1, 2019, White Company purchased $400,000 worth of inventory on credit with terms that require payment in 60 days but allow White to take a 1% discount if it pays in 10 days (often quoted as 1/10, net/60 payment terms). In the past, White has always followed the policy of making payment 30 days after the goods are purchased.

A new member of Whites staff has indicated that the company he previously worked for never passed up its cash discounts, and he wonders if this is not a sound policy. It was pointed out, however, that if White were to pay the invoice 10 days earlier, it would have to borrow the necessary funds for the 10 extra days. Whites borrowing terms with a local bank are 14% (annual rate) with a 15% compensating balance (a requirement by the bank that White maintain an amount in its account equal to 15% of the loan) for the term of the loan. Most members of Whites staff felt that it made little sense to take out a 14% loan with a compensating balance of 15% in order to save 1% on $400,000 by paying the account 10 days earlier than planned.

Required:

1. In terms of simple effective annual interest cost, explain whether it would be to Whites advantage to borrow the amount necessary to take the 1% discount by paying the bill 10 days early.

2. It has also been pointed out to White 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 pay within 30 days. Explain how your answer to Requirement 1 would change if White undertook this policy.

3. Your answer to Requirement 2 indicates that, in relation to Requirement 1, it has become either more desirable or less desirable to borrow in order to take advantage of the 1% cash discount.

   1. If you said more desirable, explain why.

   2. If you said less desirable, explain why.