Question 15.1: Estimating the Cost of Short-Term Credit The SKC Corporation...
Estimating the Cost of Short-Term Credit
The SKC Corporation plans to borrow $1,000 for a 90-day period. At maturity the firm will repay the $1,000 principal amount plus $30 interest. The effective annual rate of interest for the loan can be estimated using the APR equation, as follows.
STEP 1: Formulate a Solution Strategy
The cost of short-term credit is estimated using the annual percentage rate (APR) formula, which represents the ratio of interest to principal multiplied by the annualized time period fraction of the debt; that is,
APR = \frac{interest}{principal} \times\frac{1}{time}
Note that interest, in the APR equation above, is the product of the principal, interest rate, and time. In this example, the interest payment is adjusted to match the time period of less than 1 year. With the following equation, an annualized interest rate is adjusted so that payments match the time period of the debt.
Interest = principal × rate × time
STEP 2: Crunch the Numbers
Substituting the characteristics of SKC Corporation’s short-term credit, we get the following:
APR = \frac{ \$ 30} { \$ 1,000} \times \frac{1}{ 90 / 360}
= 0.03 × \frac{360}{90} = 0.12 = 12 %
STEP 3: Analyze Your Results
Because SKC Corporation’s bondholders require a $30 payment of interest over the 90-day time period for the principal amount of $1,000, the effective cost of borrowing short-term credit is equated by annualizing the bondholders’ required rate of return of 3 percent ($30/$1,000) over the four quarters in the year. The effective annual cost of funds provided by the loan is, therefore, 12 percent.