Parsons Company has a cash flow problem.The company owes its suppliers $300,000 on credit terms of 2/10 net 40,but Parsons doesn't have the cash to pay during the discount period.Parsons,however,can borrow the $300,000 at annual rate of 24%.Should Parsons borrow the money to pay its accounts payable?
A) No, additional borrowing will cost more for interest ($60,000 per year) than the discount is worth.
B) Yes, the effective cost of forgoing the discount is greater than 24%.
C) No, the effective cost of forgoing the discount is equal to 24%, and there are transactions costs associated with borrowing.
D) It doesn't matter because the present value of the cost of borrowing is exactly equal to the amount of the discount for paying within 10 days.

Question

Quizplus · Accepted Answer

To determine whether Parsons should borrow the money, we need to calculate the effective cost of forgoing the discount. If Parsons doesn't take the discount, it will owe $300,000 × (1 - 2%) = $294,000. If it borrows the money, it will owe $300,000 × 24% = $72,000 in interest charges. Therefore, Parsons will owe $366,000 in total, which is the cost of forgoing the discount. The effective cost of forgoing the discount is $366,000 ÷ $294,000 = 24.8%, which is greater than the annual interest rate of 24%. Therefore, it would be better for Parsons to borrow the money and take advantage of the discount.

Parsons Company Has a Cash Flow Problem