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Working Capital Financing^347

Approximate Cost-of-Credit Formula

The procedure used in estimating the cost of short-term credit is a very simple one and
relies on the basic interest equation.

(8-1) Interest = principle ◊ rate ◊ time

Where interest is the amount of interest on a principal that is borrowed at some annual
rate for a fraction of a year (represented by time). For example, a six-month loan for
Rs 1000 at 8 per cent interest would require interest payments of Rs 40:

Interest = Rs 1000 ◊ .08 ◊ 1/2 = Rs 40.

The problem faced in assessing the cost of a source of short-term financing, generally
involves estimating the annual effective rate (RATE) where the interest amount, the
principal sum, and the time for which financing will be needed are known.

Thus, solving the basic interest equation for RATE produces

(8-2) Principal Time
Rate Interest
¥

=

or Time

1

Principal

Rate = Interest ¥

Example: The SKC Corporation plans to borrow Rs 1000 for a 90-day period. At
maturity the firm will repay the Rs 1000 principal amount plus Rs 30 interest. The
effective annual rate of interest for the loan can be estimated using the RATE equation
as follows:

90/360

1

Rs 1000

Rs 30

Rate = ¥

.12,^ or^12 per cent

90

360

=. 03 ¥ =

The effective annual cost of funds provided by the loan is therefore 12 per cent.

The Annual Percentage Rate Formula

Compound interest was not considered in the simple RATE calculation. To
consider

the influence of compounding we can use the following equation:

(3-3) APR = (1 + r/m)m ñ 1

Where APR is the annual percentage rate, r is the nominal rate of interest per year (12
per cent in the above example) and m is the number of compounding periods within a
year (m = 1/TIME = 1/(90/360) = 4 in the example above. Thus, the effective rate of
interest on the example problem, considering compounding, is

APR = (1 + .12 / 4) 4 ñ 1= .126, or 12.6 per cent