Effective cost of credit to Worthington, bam 313 essay help

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.”


Effective cost of credit to Worthington

Issue price= $7,500,000


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.