Question

A large retailer obtains merchandise under the credit terms of 1/15, net 40, but routinely takes 55 days to pay its bills. (Because the retailer is an important customer, suppliers allow the firm to stretch its credit terms.) What is the retailer's effective cost of trade credit? Assume 365 days in year for your calculations. Do not round intermediate calculations. Round your answer to two decimal places.

Answer 1

Solution:

The formula for calculating the effective cost of trade credit is

= ( 1 + [Discount rate / (1 – Discount Rate )] ) ⁿ – 1

Where n= No. of days in a period / ( Total payment Period – period for which discount has been

offered)

As per the information given in the question we have

Discount rate = 1 % = 0.01 ; No. of days in a period = 365 days ;

Total payment Period = 55 days ; Period for which discount has been offered = 15 days

Total payment Period – period for which discount has been offered = 55 – 15 = 40 days

Applying the above values in the formula we have

= ( 1 + (0.01 / (1 – 0.01)) ^(365/40)   - 1                            

= ( 1 + (0.01 / 0.99)) ^(9.125)   - 1                                            

= ( 1 + 0.0101 ) ^{( 9.125 )}   - 1                                                    

= ( 1.0101 ) ^{( 7.3 )}   - 1

= 1.09605 – 1 = 0.09605 = 9.60 %                                                

Thus the effective cost of credit is = 9.60%              

Note: ( 1.0101 ) ^{( 9.125 )}   is calculated using the excel formula =POWER(Number,Power)

=POWER(1.0101,9.125) = 1.09605