Question 15.3: Calculating the Effective Cost of Credit The EPG Manufacturi...
Calculating the Effective Cost of Credit
The EPG Manufacturing Company uses commercial paper regularly to support its needs for short-term financing. The firm plans to sell $100 million in 270-day- maturity paper, on which it expects to pay discounted interest at a rate of 12 percent per annum ($9 million). In addition, EPG expects to incur a cost of approximately $100,000 in dealer placement fees and other expenses of issuing the paper. What is the effective cost of credit to EPG?
STEP 1: Formulate a Solution Strategy
EPG’s effective cost of credit can be determined using the annual percentage rate formula. By identifying each of the variables and plugging them into the APR equation, the following calculation is generated:
APR = \frac {interest} {principal} \times \frac{1} {time}
where interest is calculated using the formula
interest = (principal × rate × time) + financing fees
In this example, interest will represent the interest itself plus any other financing fees. The principal is the total cash received from financing, less any interest costs. Finally, thetime period is over 270 days.
STEP 2: Crunch the Numbers
Substituting the characteristics of EPG’s commercial paper financing strategy into equation (15-8), we get the following:
APY=\left(1+\frac{i}{m}\right)^{m}-1 (15-8)
APR = \frac{\$ 9,000,000 + \$ 100,000} {\$ 100,000,000 – \$ 100,000 – \$ 9,000,000} \times \frac{1}{270/360}
= 0.1335 = 13.35%
where the interest cost is calculated as $100,000,000 × 0.12 × (270/360) = $9,000,000 plus the $100,000 dealer placement fee. Thus, the effective cost of credit to EPG is 13.35 percent.
STEP 3: Analyze Your Results
It appears that at the 12 percent discount rate, the commercial paper sale will only return $89,900,000 in cash financing, after the $100,000 of dealer placement fees are included. This means that $9.1 million is the interest cost of financing $89.9 million. In this case, the interest represents 13.35 percent of the total cash received, which therefore represents the effective cost of credit.