Question

Assume you are the Treasurer of Mosaic, with 90-day payment term to all your vendors. If one of your large vendors offers you a 2/30,n/90 term(2% discount for 60-day early payment)on a purchase of $10,000,000.

Assume your cost of capital = 10%

a.What is the annualized cost of the discount offered by your vendor?

b.Will you accept the offer? Explain

Assuming the discount is 1/30 n/90term(1% discount for 60-day early payment)

c.What is the annualized cost of the discount offered by your vendor.

d. Will you accept the offer? Explain

Answer 1

Part a

Purchase = $ 10,000,000 Discount on earlier payment = 2% on Purchase = $ 200,000  

Cost of Capital = 10% pa.

Annualized cost = {360 / (Normal payment period - Discount period)} * {(Discount in % / 100 - Discount in %)

Steps to calculate Annualized cost :

1. Calculate the time gap between discount period and normal payment period, = 90 - 30 = 60 days.

2. Divide 360 days in year by time gap = 360/60 = 6

3. Calculate (Discount / 100 - Discount) 2%/ (100-2) = 2 / 98 = 0.0204

4. Annualized Cost of Discount offered = 6 * 0.0204 = 0.1225 or 12.25%

Part B

Now since Cost of Capital is less that of Return from discount offered, the proposal of credit term should be accepted.

If  the discount is 1/30 n/90term

Part A

Annual Cost of Discount  = {360 / (Normal payment period - Discount period)} * {(Discount in % / 100 - Discount in %)

= {360 / (90-30)} * { (1% / (100 - 1) } = 6 * 0.01010 = 0.0606 or 6.06 %

Part B

Since cost of capital is 10 % which is more that the return offered by discount, the proposal shall be rejected.