Question

Problem 16-03

Cost of Trade Credit

What are the nominal and effective costs of trade credit under the credit terms of 1/10, net 30? Assume 365 days in a year for your calculations. Round your answers to two decimal places. Do not round intermediate calculations.

Nominal cost of trade credit %

Effective cost of trade credit %

Answer 1

Solution:

Calculation of Nominal cost of trade credit :

The formula for calculating the Nominal cost of trade credit is

= [ Discount % / ( 100 – Discount % ) ] * [ 365 / ( Days allowed for payment - Discount period ) ]

As per the information given in the question we have

Discount % = 1 %    ; Discount period = 10 days ; Days allowed for payment = 30 days   ;

Applying the above values in the formula we have

= [ 1 / ( 100 – 1 ) ] * [ 365 / ( 30 – 10 ) ]

= ( 1 / 99 ) * (365 / 20 )

= 0.010101 * 18.25

= 0.184343

= 18.4343 %

= 18.43 % ( when rounded off to two decimal places )

Thus the Nominal cost of trade credit is = 18.43 %

Calculation of Effective cost of trade credit:

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 / ( Days allowed for payment – Discount period )

As per the information given in the question we have

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

Days allowed for payment = 30 days ; Discount period = 10 days

Days allowed for payment - Discount period = 30 – 10 = 20 days

Applying the above values in the formula we have

= ( 1 + (0.01 / (1 – 0.01)) ^(365/20)   - 1                            

= ( 1 + (0.01 / 0.99)) ^(365/20)   - 1

= ( 1 + (0.01 / 0.99)) ^(18.25)   - 1                                                    

= ( 1 + 0.010101 ) ^{( 18.25 )}   - 1                                           

= ( 1.010101 ) ^{( 18.25 )}   - 1

= 1.201317 – 1

= 0.201317  

= 20.1317 %

= 20.13 % ( when rounded off to two decimal places )                    

Thus the effective cost of credit is = 20.13 %              

Note: ( 1.010101 ) ^{( 18.25 )}   is calculated using the excel formula =POWER(Number,Power)

=POWER(1.010101,18.25) = 1.201317