Question 19.3: Your firm purchases goods from its supplier on terms of 1/15...
Your firm purchases goods from its supplier on terms of 1/15, net 40. What is the effective annual cost to your firm If it chooses not to take advantage of the trade discount offered?
PLAN
Using a $100 purchase as an example, 1/15, net 40 means you get a 1 % discount if you pay within 15 days, or you can pay the full amount within 40 days. 1 % of $100 is a $1 discount, so you can either pay $99 in 15 days, or $100 in 40 days. The difference is 25 days, so you need to compute the interest rate over the 25 days and then compute the EAR associated with that 25-day Interest rate.
EXECUTE
$1/$99 = 0.0101, or 1.01% interest for 25 days. There are 365/25 = 14.6 25-day periods in a year. Thus, your effective annual rate is (1.0101 )^{14.6} – 1 = 0.158, or 15.8%.
EVALUATE
If you really need to take the full 40 days to produce the cash to pay, you would be better off finding a bank that would lend you the $99 at a lower rate so you could take advantage of the discount.