Question

a. Company UX manufactures glassware. Supplier DQ provides raw material to Company UX under the credit terms of 1/15 net 40. i. Determine the cost of giving up the cash discount from Supplier DQ. Your answer should be in percentage and rounded to two decimal places. ii. Bank JW offers short-term financing to Company UX at a premium of 5% above PRIME. If the current PRIME rate is 11% p.a; what is the cost of bank borrowing for Company UX? iii. Given your answers in (i) and (ii), should Company UX take up the cash discount from Supplier DQ? If the invoice amount is $80,000, determine when and how much should Company UX pay.

Answer 1

(i) Credit terms of 1/15 net 40 means the invoice amount should be payable by Company UX within 40 days, but if it is paid within 15 days, a cash discount of 1% will be provided by supplier DQ. So the cost of giving up the cash discount from supplier would be 1% of the invoice amount.

(ii) Cost of bank borrowing for Company UX would be 16% [i.e. PRIME rate (11%) + 5% margin]

(iii) If invoice amount is $80000 and if payment is made after 15 days, then cost of giving up cash discount would be $800.

However, if Company UX thinks of borrowing amount at 16% p.a. for 40 days and makes payment to Supplier DQ within 15 days to avail cash discount, then net cost would be:

Interest payable on short-term financing=80000*16%*40/365 = $1403

Benefit from Cash Discount = 1% of $80000 = $800

Net cost would be $603

So it can be seen that net cost to Company UX would be less if it borrows money from bank and pays the amount within 15 days to avail cash discount, rather than waiting for 40 days to make the payment from own sources and foregoing the discount.