Question

Problem 16-04
Cost of Trade Credit

A large retailer obtains merchandise under the credit terms of 3/20, net 45, but routinely takes 50 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 as follows :

Effective cost of trade credit = ( 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 = 3 % = 0.03   ; No. of days in a period = 365 days ;

Total payment Period = 50 days ; Period for which discount has been offered = 20 days

Total payment Period – period for which discount has been offered = 50 – 20 = 30 days

Applying the above values in the formula we have

= ( 1 + (0.03 / (1 – 0.03)) ^(365/30)   - 1                          

= ( 1 + (0.03 / 0.97)) ^(12.166667)   - 1                             

= ( 1 + 0.030928 ) ^{( 12.166667 )}   - 1                                

= ( 1.030928 ) ^{( 12.166667 )}   - 1

= 1.448588 – 1 = 0.448588

= 44.8588 %                                                                                 

= 44.86 % ( when rounded off to two decimal places )

Thus the effective cost of credit is = 44.86 %

Note: The value of ( 1.030928 ) ^12.166667   is calculated using the Excel function =POWER(Number,Power). Thus ( 1.030928 ) ^12.166667   =POWER(1.030928,12.166667) = 1.448588