Question

Sam receives a bill with the terms 2.5/15 n/60. If he can borrow money at a simple interest

rate of 18%, does it make sense for him to do this to take advantage of the discount? Justify your answer.

Answer 1

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While making evaluation we should compare opportunity cost of forgoing cash discount and cost of borrowing.

Cost of annual borrowing = 18%

Now cost of foregoing cash discount shall be found.

Terms are 2.5/15 n/60: It means if payment is made within 15 days then discount of 2.5% will be given, if not, the complete payment must be made within 60 days.

If payment is made within 15 days we have to pay only 100 - 2.5 = 97.5% amount

Therefore on payment of 97.5 we will get discount of 2.5.

Hence cost of cash discount = 2.5 / 97.5

This cost of cash discount is when we make payment 60 – 15 = 45 days earlier

Therefore, cost of cash discount for one day = (2.5 / 97.5) * (1/45)

For comparing, we should calculate cost of cash discount for complete year.

Assuming there are 365 days in a year,

Cost of cash discount for a year = (2.5 / 97.5) * (1/45) * 365

                                                         = .20798 or 20.798%

Hence, if the cash discount is availed there will be saving of 20.798% and the cost of borrowing is 18%.

Therefore, benefit of cash discount shall be availed.