Question

ABC Ltd. has revenue of N$500 million and sells all of its goods on credit to a variety of different wholesale customers. At the moment the company offers a standard credit period of 30 days. However, 70% of its customers (by revenue) take an average of 70 days to pay, while the other 30% of customers (by revenue) pay within 30 days. The company is considering offering a 2% discount for payment within 30 days and estimates that 80% of customers (by revenue) will take up this offer (including those that already pay within 30 days).

The Managing Director has asked the credit controller if the cost of this new policy would be worth offering. The company has a £80 million overdraft facility that it regularly uses to the full limit due to the lateness of payment and the cost of this overdraft facility is 15% per annum.

The credit controller also estimates that bad debt level of 2% of revenue would be halved to 1% of revenue as a result of this new policy.

Required

1. Calculate the approximate equivalent annual percentage cost of a discount of 2%, which reduces the time taken by credit customers to pay from 70 days to 30 days.
2. Calculate the value of trade receivables under the existing scheme and the proposed scheme at the year-end.
3. Evaluate the benefits and costs of the scheme and explain with reasons whether the company should go ahead and offer the discount. You should also consider other factors in this decision. (Hint: You need to work out the cost of the discount compared to the interest on the overdraft saved and bad debt reduction.)

Answer 1

1.Approximate equivalent annual percentage cost of a discount of 2%, which reduces the time taken by credit customers to pay from 70 days to 30 days
(Discount %/(1-Discount%))*(360/(Current av.payment days-Proposed Discount days))
ie. (2%/(1-2%))*(360/(70-30))=
18.37%
2. Value of trade receivables under the existing scheme (500*70%)	350
Value of trade receivables under the porposed scheme (500*(1-80%))	100
Reduction in trade receivables(money available early )	250
3.Incremental collections (ie. Out of the 70% customers)-net of discounts(250*(1-18.37%)	204.075
Cost of discounts(250*18.37%)-------------------------------------------1	45.925
Benefits
Reduction OD interests to the extent of collection (204.075*15%)	30.6113
Reduction OD interests to the extent of reduced bad debt collection (500*1%*15%)	0.75
Total benefits of extending discounts to the 70% customers--------2	31.3613
Comparing 1 & 2, costs of offering cash discounts (in $) exceed the benefits/ reduction in OD interest expenses, the discount scheme is NOT RECOMMENDED.