Question

Suppose a firm makes purchases of Rs 10.95 million per year under terms of 2/10, net 30, and takes
discounts.
i. What is the average amount of accounts payable net of discounts? (Assume the Rs 10.95
million of purchases is net of discounts—that is, gross purchases are Rs 11,173,469.40,
discounts are Rs 223,469.40, and net purchases are Rs 10.95 million.)
ii. Is there a cost of the trade credit the firm uses?
iii. If the firm did not take discounts but did pay on the due date, what would be its average
payables and the cost of this nonfree trade credit?
iv. What would be the firm’s cost of not taking discounts if it could stretch its payments to
40 days?

Answer 1

Answer : i ) Average Amount of Accounts Payable = (Net Credit Purchase / 365 ) * 10 days

= (10,950,000 / 365) * 10

= 300,000

(ii) There is no cost of trade credit that the firm uses

(iii) Average Amount of Accounts Payable (Net of Discounts) = (Net Credit Purchase / 365 ) * 30 days

= (10,950,000 / 365) * 30

= 900,000

Calculation of Nominal Cost = [Discount % / (100 % - Discount %)] * [365 / (Total Credit period - Payment Period)]

= [2% / (100% - 2%)] * [365 / (30 - 10)]

= [2% / 98%] * [ 365 / 20]

= 0.3724 or 37.24%

Calculation of Effective Cost

Effective Cost = {1 + [Discount % / (100 % - Discount %)] ^ [365 / (Total Credit period - Payment Period)]

   = { 1 + [2% / (100% - 2%)]} ^ [365 / (30 - 10)] - 1

  = { 1 + [2% / 98%]} ^ [ 365 / 20] - 1

= 1.4459 - 1

= 0.4459 or 44.59%

(iv) Calculation of  firm’s cost of not taking discounts if it could stretch its payments to 40 days :

Calculation of Nominal Cost = [Discount % / (100 % - Discount %)] * [365 / (Total Credit period - Payment Period)]

= [2% / (100% - 2%)] * [365 / (40 - 10)]

= [2% / 98%] * [ 365 / 30]

= 0.2483 or 24.83%

Calculation of Effective Cost

Effective Cost = {1 + [Discount % / (100 % - Discount %)] ^ [365 / (Total Credit period - Payment Period)]

   = { 1 + [2% / (100% - 2%)]} ^ [365 / (40 - 10)] - 1

  = { 1 + [2% / 98%]} ^ [ 365 / 30] - 1

= 1.2786 - 1

= 0.2786 or 27.86%