Question

Pets Store Inc. sells on terms of 1/20, net 65. What is the effective annual cost of trade credit under these terms? Use a 365-day year.

Answer 1

Solution:

The formula for calculating the effective annual cost of trade credit is

= ( 1 + [ Discount rate / (1 – Discount Rate ) ] ) ⁿ – 1

Where n= No. of days in a period / ( Total payment Period – period for which discount has been

offered)

As per the information given in the question we have

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

Total payment Period = 65 days ; Period for which discount has been offered = 20 days

Total payment Period – period for which discount has been offered = 65 – 20 = 45 days

Applying the above values in the formula we have

= ( 1 + (0.01 / (1 – 0.01)) ^(365/45)   - 1                            

= ( 1 + (0.01 / 0.99)) ^{( 8.1111)}   - 1                                     

= ( 1 + 0.0101 ) ^{( 8.1111 )}   - 1                                              

= ( 1.0101 ) ^{( 8.1111 )}   - 1

= 1.0849 – 1 = 0.0849   = 8.49 %                                                  

Thus the effective annual cost of credit is = 8.49 %

Note: ( 1.0101 ) ^{( 8.1111 )}   is calculated using the excel formula =POWER(Number,Power)

=POWER(1.0101,8.1111) = 1.0849