A firm faces a liquidity crunch and must decide between borrowing from a bank at 12% interest and stretching its payables for one quarter.If it stretches the payables it will forgo a 2% discount for timely payment.Based solely on cash flows, which would you suggest?

Question

Quizplus · Accepted Answer

By stretching the payables for one quarter, the firm will save 2% in discounts but will have to pay an additional cost of financing for that period. To determine which option is better, we need to calculate the cost of financing for stretching payables and compare it to the cost of borrowing from the bank. The cost of financing can be calculated using the following formula:

Cost of Financing = (Discount % / (100% - Discount %)) x (365 / (Payment Days - Discount Days))

In this case, the discount is 2%, and the payment days are extended by one quarter or 90 days. The discount days are assumed to be 10. Therefore, the cost of financing for stretching payables is:

Cost of Financing = (2% / (100% - 2%)) x (365 / (90 - 10)) = 3.76%

This means that the cost of stretching payables for one quarter is 3.76%, which is lower than the interest rate of 12% offered by the bank. Therefore, it is better for the firm to stretch payables and finance at a savings of approximately 3.76% annually.

A Firm Faces a Liquidity Crunch and Must Decide Between