Interest is the amount usually paid on the use of the principal amount of money loaned. Effective interest rate is the “actual annual interest rate that accrues, after taking into consideration the effects of compounding, when compounding occurs more than once per year (Investorwords, 2007). If Bright Flashlight Company will loan $300,000 from the bank for 60 days, the effective interest rate on the bank loan is 11% for a year or 1. 83% for the 60-days period.
Opportunity cost is the cost difference of one alternative action over another. If Bright Flashlight Company will not pay their purchases amounting to $300,000 within the 10 day period, they will lose the opportunity to take the 10% discount amounting to $6,000. On the other hand, if they do not pay within the discount period, they also have the opportunity to use the $300,000 for other ventures within the credit term given by the supplier.
Based on the given data, I think that Bright Flashlight Company should borrow the money from the bank in order to take the discount on their purchases. The company can take the 2% cash discount in 10 days amounting to $6,000 and pay $5,500 interest on the bank loan of $300,000 after 60 days. The difference of $500 is still favorable for Bright Flashlight Company even if they pay their purchases after 70 days. If the banker requires a 20% compensating balance, Bright Flashlight Company must borrow $360,000 from the bank.
The difference between the $360,000 loan and $300,000 needed fund of the company; amounting to $60,000 (20% of $300,000) is the banks compensating balance. However, if this is the case, Bright Flashlight Company should not loan from the bank anymore since interest on the loan will increase because of the increase on the total principal amount of the loan.
Investorwords (2007). Retrieved February 10, 2007 from: http://www. investorwords. com/1661/effective_annual_interest_rate. html
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