Question

1) A firm received an invoice of $800, 000 from a supplier with the terms 2/5, Net 40. It will receive 2% discount if paying by the 5th day, or pay the full amount by the 40th. Day. The firm’s cost of capital is 8%. Using the PV of Trade terms, evaluate the decision.

Answer 1

Cost of not taking credit = (1 + Discount %/(1-Discount %)](# days in a year/(Full allowed payment days - Discount days)] 2% 360 [Assuming nominal interest rate method is used] 40 Discount % #days in a year Full allowed payment days Discount days Effective annual rate of interest (EAR) (Cost of not taking credit) 23.10% [Ref: NOTE] Because cost of not taking credit (23.10%) is more than cost of capital (8%) of the firm, it is advisable to avail trade credit. Otherwise, though firm will enjoy extended credit days, it will cost more to the firm for availing credit days. NOTE: Here, the term 2/5, net 40 refers to 2% discount with discount period of 5 days and credit term of 40 days. EAR = [1+[2% / (1-2%)][360/(40 - 5)] - 1 = [1+ 2%/98%)(360/35) - 1 = 0.2310 = 23.10%