Question 19.7: What is the effective annual cost of credit terms of 1/15, n...
What is the effective annual cost of credit terms of 1/15, net 40 If the firm stretches the accounts payable to 60 days?
PLAN
First, we need to compute the interest rate per period. The 1% discount means that on a $100 purchase, you can either pay $99 in the discount period, or keep the $99 and pay $100 later. Thus, you pay $1 interest on the $99. If you pay on time, then this $1 in interest is over the 25-day period between the 15th day and the 40th day. If you stretch, then this $1 in interest is over the 45-day period between the 15th day and the 60th day.
EXECUTE
The interest rate per period is $1/$99 = 1.01%. If the firm delays payment until the 60th day, it has use of the funds for 45 days beyond the discount period. There are 365/45 = 8.11 45-day periods in one year. Thus, the effective annual cost is (1.0101 )^{8.11} – 1 = 0.0849, or 8.49%.
EVALUATE
Paying on time corresponds to a 25-day credit period and there are 365/25 = 14.6 25-day periods in a year. Thus, if the firm pays on the 40th day, the effective annual cost is (1.0101 )^{14.6} – 1 = .1580, or 15.8%. By stretching its payables, the firm substantially reduces its effective cost of credit.