Answer:
a. The amount of free trade credit that Hammington obtains from the major supplier can be calculated using the credit terms. In this case, the terms are 1/15, net 60. This means that if Hammington pays within 15 days, they can take a 1% discount. Therefore, the amount of free trade credit is the difference between the gross amount and the discounted amount:
Free Trade Credit = Gross Amount - Discounted Amount
Free Trade Credit = $300,000 - ($300,000 * 0.01)
Free Trade Credit = $300,000 - $3,000
Free Trade Credit = $297,000
b. The amount of costly trade credit is the difference between the gross amount and the net amount paid after the credit period:
Costly Trade Credit = Gross Amount - Net Amount
Costly Trade Credit = $300,000 - $300,000
Costly Trade Credit = $0
c. The approximate annual percentage cost of the costly trade credit can be calculated using the following formula:
Costly Trade Credit Percentage = (Costly Trade Credit / Gross Amount) * (360 / Credit Period)
Costly Trade Credit Percentage = ($0 / $300,000) * (360 / 60)
Costly Trade Credit Percentage = 0
Since the costly trade credit has no cost (as the payment is made within the credit period), the annual percentage cost is 0%.
d. If the bank loan is used regardless of the cost of trade credit, Hammington should replace the trade credit up to the amount of the costly trade credit. As calculated in part b, the costly trade credit is $0, so no trade credit should be replaced with the bank loan.
e. Based on the calculations, there is no costly trade credit, and the bank loan has a lower cost compared to the trade credit (which has a cost of 0%). Therefore, it would be recommended for Hammington to replace its trade credit with the bank loan as it would result in lower financing costs.