Answer in 3 steps with explanation at the end of each step and final answer at the end:

5
.

(
1
0

p
t
s
)
Answer your choice
o
f
one
o
f
the following three questions.
a
.
Suppose you b

Question

Answer in 3 steps with explanation at the end of each step and final answer at the end:

5
.
 
(
1
0
 
p
t
s
)
 ﻿Answer your choice 
o
f
 ﻿one 
o
f
 ﻿the following three questions.
a
.
 ﻿Suppose you buy bricks for your masonry business from Mid
-
South Brick Supply Inc. They give
you credit terms 
o
f
 
2
1
5
,
 ﻿net 
6
0
 
o
n
 ﻿the bricks. Calculate the effective annual rate implied 
b
y
 ﻿the
credit terms. 
I
f
 ﻿your firm has a WACC 
o
f
 
2
0
%
,
 ﻿how many days after the purchase should you
pay your supplier? Why? Does your answer change 
i
f
 ﻿your firm
’
s
 ﻿WACC 
i
s
 
1
5
%
?
 ﻿
b
.
 ﻿From the perspective 
o
f
 ﻿a manager, compare and contrast dividends and repurchases using
payout policy theory and empirical evidence. Why would you issue dividends 
t
o
 ﻿investors? Why
would you forgo dividends, opting instead for share repurchases?
c
.
 ﻿Describe adjustments a manager can make 
t
o
 ﻿inventory management and credit policy 
t
o
 ﻿
improve the cash conversion cycle. What are the risks 
o
f
 ﻿making these adjustments?

VIPSolutions · Accepted Answer

Let's answer **question a** step by step:

---

### **Step 1: Calculate the effective annual rate (EAR) implied by the credit terms 2/15, net 60.**

**Explanation:**  
- **2/15, net 60** means:  
  - 2% discount if paid within 15 days; otherwise, the full amount is due in 60 days.
- If you don't take the discount, you are essentially borrowing the invoice amount for an additional (60-15)=45 days at a cost of 2%.

The formula to calculate EAR for such terms is:
$$
\text{EAR} = \left(1 + \frac{\text{Discount \%}}{1 - \text{Discount \%}}\right)^{\text{365/Days deferred}} - 1
$$

Here:
- Discount % = 2% = 0.02
- Days deferred = 60 - 15 = 45

So,
$$
\text{EAR} = \left(1 + \frac{0.02}{0.98}\right)^{365/45} - 1
$$
$$
\frac{0.02}{0.98} = 0.020408
$$
$$
1 + 0.020408 = 1.020408
$$
$$
\frac{365}{45} \approx 8.111
$$
$$
1.020408^{8.111} \approx e^{8.111 \times \ln(1.020408)} \approx e^{0.164} \approx 1.178
$$
$$
\text{EAR} \approx 1.178 - 1 = 0.178 \text{ or } 17.8\%
$$

**Conclusion for Step 1:**  
The effective annual rate implied by the credit terms is **about 17.8%**.

---

### **Step 2: Compare company WACC with EAR to decide when to pay.**

**Explanation:**  
- If your firm's WACC is **20%**, it's higher than the EAR (17.8%).  
  - Paying late (after 15 days, on day 60) is **cheaper** than using your own capital (since 17.8% < 20%).
- If your firm's WACC is **15%**, it's less than the EAR (17.8%).
  - Paying late is **more expensive** than using your own capital (since 17.8% > 15%).

**Conclusion for Step 2:**  
- **WACC = 20%:** Pay on day **60** (take supplier's "loan").
- **WACC = 15%:** Pay on day **15** (take the 2% discount).

---

### **Step 3: Explain why and summarize the final recommendation.**

**Explanation:**  
- You should compare the cost of not taking the discount (EAR) to your own cost of capital (WACC).
- If the supplier's "loan" (i.e., not taking the discount) is cheaper than your WACC, you should pay at the end of the period (day 60).
- If your own cost of funds is cheaper, you should pay early and take the discount.

**Final Answer:**  
- The effective annual rate implied by the credit terms 2/15, net 60 is **about 17.8%**.
- If your firm's WACC is **20%**, you should **pay your supplier on day 60** (do not take the discount), because borrowing from the supplier is cheaper than your own capital.
- If your firm's WACC is **15%**, you should **pay your supplier on day 15** (take the 2% discount), because your own capital is cheaper than the supplier's implicit rate.

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