The way to solve this is to calculate the effective annual percentage rate of each of the three types of borrowing. Commercial paper: The commercial paper is issued quarterly. The question does not state when each commercial paper issuance is due, so we must assume that each one will be paid off by the next one, that is, in 3 months. Therefore, the amount outstanding for one year will be a continuous amount of $8,800,000. The amount of interest that will be payable each quarter for that outstanding balance will be the difference between $9.1 million and $8.8 million, which is $300,000. To convert that quarterly interest payment to an annual interest amount, we multiply it by 4. The annual interest due will thus be $1,200,000. So the annual percentage rate for the commercial paper will be $1,200,000 ÷ $8,800,000, which is 13.64%. Bank: This rate is given as 12%. Suppliers: The formula to calculate the cost of not taking a supplier’s discount is: 360 × Discount % Total period for payment ? Period for discount payment 100% ? Discount % Duoplan's cost of trade credit is: 360 × .02 90 ? 30 1.00 ?.02 = 6 × .020408 = .1224 or 12.24%. So the bank’s rate is the lowest of the three.
The commercial paper is issued quarterly. The question does not state when each commercial paper issuance is due, so we must assume that each one will be paid off by the next one, that is, in 3 months. Therefore, the amount outstanding for one year will be a continuous amount of $8,800,000. The amount of interest that will be payable each quarter for that outstanding balance will be the difference between $9.1 million and $8.8 million, which is $300,000. To convert that quarterly interest payment to an annual interest amount, we multiply it by 4. The annual interest due will thus be $1,200,000. So the annual percentage rate for the commercial paper will be $1,200,000 ÷ $8,800,000, which is 13.64%. This is not the lowest available cost of funds.
The rates on the three options are different enough that, based on the outstanding borrowings, the difference in the interest costs will be significant.
The formula to calculate the cost of not taking a supplier's discount is: 360 × Discount % Total period for payment ? Period for discount payment 100% ? Discount % Duoplan's cost of trade credit is: 360 × .02 90 ? 30 1.00 ?.02 = 6 × .020408 = .1224 or 12.24%. This is not the lowest available cost of funds.
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