Question

A supplier to your firm offers credit terms of 2/15 net 45 however, your firm never

takes advantage of the discount but instead always pays full price on day 45. Your

finance intern claims that your firm would be better off borrowing money from an

existing but little used line of credit at a current annualized rate of 8%, pay the firm

providing credit at the end of the discount period (day 15) and to then repay the line of

credit 30 days later on day 45. She argues that the cost to your firm would be lower than

current practice. What is the effective cost to the firm of not utilizing the discount vs,

the cost of borrowing money to take advantage of the discount? Please show your work

and provide your answers in percentage terms.

Answer 1

Cost of not utilising the supplier- discount is calculated using the formula,

(Discount %/(100%- Discount %))*(365/(Net days allowed -Discount days))

So, for 2/15,net 45 terms,the effective annual cost of not availing the trade- discount will be :

(2%/(100%-2%))*(365/(45-15))

24.83%

Cost of borrowing money to take advantage of the discount

As is given, the annualised cost of the funds needed is 8%

As 8% < 24.83% , it is only prudent to borrow, using the already available line of credit & avail the trade discount & make early payment to the supplier.