Question Three
Worthington, Inc. is planning to issue $7,500,000 in 120-day maturity notes carrying a rate of 11 percent per year. Worthington’s commercial paper will be placed at the cost of $35,000. What is the effective cost of credit to Worthington?
The effective cost of credit typically entails determining the cost of getting a certain amount of funds to be utilized within a particular investment. Currently, Worthington, Inc. plans to issue $7,500,000 in a 120-day maturity note at a rate of 11 percent annually. Here the company will borrow money in the form of a loan and commit and to pay the total amount 120 days after it has borrowed the funds. Nevertheless, an interest of 11 percent has been entitled together with the sum amount loan as nothing comes for free. These implied the firm would pay a higher amount of money than the initial amount given which will be the principal amount of $7,500,000 plus interest accrued.
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Moreover, Worthington, Inc. has an expense cost that it will incur. The firm’s commercial paper is approximated to cost $35000. Some of the expenses included transportation cost, the tax imposed, insurance and other charges that are essential to securing credit. Normally, a year usually has 365 days. In this case, scenario, let’s assume the year has 360 days. Worthington, Inc. has set out to pay with 120 days which is one-third of the year. On the other hand, 11 percent is the percentage rate for the whole year. Taking the payment period will only be one-third of the year the payable interest will be (0.11 * 1/3) which constitute 3.67% in assumption. In the determination of the interest amount, the principal amount of 7,500,000 will be a subject of the annual rate, in which the expenses incurred will be added.
When computing the effective cost of credit for the Worthington, Inc., one of the formula’s used is the annual percentage formula. It calculation comprises of
APR = Interest * 1
Principal Time
But from the above description, there is no interest calculated. Assuming the year has 360 days: (calculation of interest) will compose of
Interest = (Principal * Rate * Time) + financing Fees
= (7,500,000 * 0.11 * 120/360) + 35000
= (7500000 * 0.11 * 1/3) + 35000
= 275000 + 35000
=$ 310000
Having the interest, it will help in substituting for the APR which will assist in getting the effective cost of credit.
APR = Interest * 1
Principal Time
APR = 275000+ 35000 * 1
7,500,000 – 35000 -275000 120/360
= 310000/7190000 * 1
120/360
= 0.04311544 * 3.000
=0.1293 approximating to 12.93%
From the above calculations, the payable interest cost amounted to $310000 when the cost incurred is added. The effective cost of credit to Worthington Inc. is 12.93%. The 11 percent discounted rate will aid in cash financing. The $310000 is the interest cost that will be incurred by Worthington, Inc. The 12.93% represents the percentage of the total cash received thus is the effective cost of credit.
References
Keown, A. M. (2014). Foundations of Finance, 8th Edition. Upper Saddle River, NJ: Prentice Hall.
