FIN 081 – Trade Credit

Activity 2

Comprehensive Problems

Problem 1

Alinor’s Designs just recently opened as upscale dress shop in northeast Florida. The owner is trying to
decide whether to take the discount offered from his suppliers, or whether to pay at the end of the
month. Diana’s suppliers are offering her a 3% discount if she pays within 15 days; otherwise, the
balance is due 45 days after purchase. What are Alinor’s approximate and effective annual costs of trade
credit? (Assume a 360-day year.)

Answer:
𝟑 𝟑𝟔𝟎
Approximate rate = 𝒙
𝟗𝟕 𝟒𝟓−𝟏𝟓
𝟑
= 𝒙 𝟏𝟐
𝟗𝟕

= 37.11%

3 360⁄
Effective Interest rate = (1 + ) 30 -1
97
3 12
= (1 + ) -1
97

= 44.12%

Problem 2

Candy Hypermarket purchases P4,562,500 in goods over a 1-year period from its sole supplier. The
supplier offers trade credit under the following terms: 2/15, net 55 days. (Assume a 360-day year.)

Requirements:

1. If Hayes chooses to pay on time but not to take the discount, what is the average level of the
company’s accounts payable.
2. What is the effective annual cost of its trade credit?
3. What is the free trade credit?
4. What is the costly trade credit?
 𝐴𝑣𝑒. 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒
1. PDP = 𝑃𝑢𝑟𝑐ℎ𝑎ℎ𝑒𝑠
( 360
)

𝐴𝑣𝑒. 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒

55 = 4,562,500
( 360
)

𝐴𝑣𝑒. 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒

55 =
12,673.61

Ave. Accounts payable = 55 x 12,673.61

Ave. Accounts payable = P697,048.61

2 360⁄
2. Effective Interest rate = (1 + ) 40 -1
98
2 9
= (1 + ) -1
98

= 19.94%
3. Free trade Credit:
𝐴𝑣𝑒. 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒
PDP = 𝑃𝑢𝑟𝑐ℎ𝑎ℎ𝑒𝑠
( 360
)

𝐴𝑣𝑒. 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒

15 = 4,562,500
( 360
)

𝐴𝑣𝑒. 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒

15 =
12,673.61

Ave. Accounts payable = 15 x 12,673.61

Ave. Accounts payable = P190,104.17 (Free trade credit)
4. Costly trade credit:
𝐴𝑣𝑒. 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒
PDP = 𝑃𝑢𝑟𝑐ℎ𝑎ℎ𝑒𝑠
( 360
)

𝐴𝑣𝑒. 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒

40 = 4,562,500
( 360
)
 𝐴𝑣𝑒. 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒
40 =
12,673.61

Ave. Accounts payable = 40 x 12,673.61

Ave. Accounts payable = P506,944.44 (costly trade credit)

Notes: Trade credits simply means, the accounts receivable or the accounts payable

Free trade credit + Costly trade credit = Trade Credits

190,104.17 + 506,944.44 = 697,048.61

Free trade credit – Is the Accounts payable/receivable if the discount is taken.
Costly trade credit = Trade credits – Free trade credit

Alternative Formula
15
Free trade credit = 697,048.61 x
55

=190,104.17
40
Non-free trade credit = 697,048.61 x
55

= 506,944.44

Problem 3

Compute the effective annual cost of foregoing the cash discount for each of the following:

Supplier A 3/10, net 50

Supplier B 3/15, net 45
Supplier C 2/10, net 70
Assuming that the firm needs short-term financing, recommend whether it would be better to give up
the cash discount or take the discount and borrow from a bank at 20% annual interest. Evaluate each
supplier separately. (Assume a 360-day year.)
Answer:
3 360⁄
Effective Interest rate Sup. A = (1 + ) 40 -1
97
3 9
= (1 + ) -1
97

= 31.54%
3 360⁄
Effective Interest rate Sup. B = (1 + ) 30 -1
97
3 12
= (1 + ) -1
97

= 44.12%
2 360⁄
Effective Interest rate Sup. C = (1 + ) 60 -1
98
2 6
= (1 + ) -1
98

= 12.89%
Note: The rationale behind this problem is whether you take the discount or not.
By taking the discount, you must borrow from the bank that requires 20%
interest. As a manager, you must decide the best course of action.
Option 1: Forgo the discount, and pay it at due date
Option 2: Borrow from the bank, and take advantage of the discount.
Supplier Effective Annual cost Annual interest of Bank Decision
A 31.54% 20% Borrow and take
the discount
B 44.12% 20% Borrow and take
the discount
C 12.89% 20% Forgo the
discount
Problem 4

Liana buys on terms of 2/10, net 30, but generally does not pay until 40 days after the invoice date. Its
purchases total P1,080,000 per year.

Requirements:

1. What is the approximate cost of the “non-free” trade credit?

2. What is the Effective interest rate of the “non-free” trade credit?
3. How much “non-free” trade credit does the firm use on average each year?

Answers
𝟐 𝟑𝟔𝟎
1. Approximate rate = 𝒙
𝟗𝟖 𝟒𝟎−𝟏𝟎
𝟐
= 𝒙 𝟏𝟐
𝟗𝟖

= 24.49%

2 360⁄
2. Effective Interest rate = (1 + ) 30 -1
98
2 12
= (1 + ) -1
98

= 27.43%
3. Free trade Credit:
40 – 10 = 30 days
𝐴𝑣𝑒. 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒
PDP = 𝑃𝑢𝑟𝑐ℎ𝑎ℎ𝑒𝑠
( 360
)

𝐴𝑣𝑒. 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒

30 = 1,080,000
( )
360

𝐴𝑣𝑒. 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑝𝑎𝑦𝑎𝑏𝑙𝑒

30 =
3,000

Ave. Accounts payable = 3,000 x 30

Ave. Accounts payable = P90,000