Answer & Explanation:My professor failed my essay again. Here are her notes to me: “Your answer is close, but incorrect. Please review effective finance costs and short term financing in your textbook-it provides detailed examples.”CAN ANY ONE HELPEffective
cost of credit to Worthington
Issue price= $7,500,000
Maturity=120-day
Rate =11 % per year
Floatation cost= $35,000
Interest= (11%/365) ×120 ×
(7,500,000)
= $271,232.88
Total costs= $271,232.88+35,000
= $306,232.88
Effective cost=
($306,232.88/7,500,000) ×365/120 =12.42%
Effective
cost of credit to Worthington
Worthington Inc. incurs both transaction and financial costs when they issue the
120 day note. Financial costs include interest, forced savings, fees and
contributions to insurance fund.
Transaction costs refers to the money paid out to access the loan.
Transaction costs include the cost incurred to process the 120 days note. The
interest paid is to compensate the lenders who would have used this money to
invest in other interest earning investments.
The
effective cost of credit in this case is the sum of the interest rates given to
the lenders and the transaction costs used in processing the loan. The
effective cost of credit is of 12.42%% is higher than the interest rates of
11%. This rate means that the company pays 12.42% for every dollar borrowed.
The company’s returns from investments financed by this loan should therefore
be higher than the effective cost of credit. This is because the effective cost
of credit includes the transaction costs which are not accounted for in the
nominal interest rates.
