Asked by Justin Berry on Apr 28, 2024
Verified
Suppose the credit terms offered to your firm by your suppliers are 2/10,net 30 days.Out of convenience,your firm is not taking discounts,but is paying after 25 days,instead of waiting until Day 30.You point out that the nominal cost of not taking the discount and paying on Day 30 is approximately 37%.But since your firm is not taking discounts and is paying on Day 25,what is the effective annual cost (NOT the nominal cost) of your firm's current practice,using a 365-day year?
A) 60.3%
B) 63.5%
C) 66.7%
D) 70.0%
Effective Annual Cost
This term refers to the total cost of borrowing on an annual basis, including interest and any fees, taking compounding into account.
Nominal Cost
The original cost of an asset or investment, not adjusted for inflation or other factors affecting its current value.
Trade Credit
An arrangement to buy goods or services on account, that is, without making immediate cash payment, usually evidenced by an invoice.
- Acquire knowledge about the effects of skipping discounts on trade credit arrangements.
Verified Answer
Effective Annual Cost = [(1+ Discount %)/(1- Discount %)]^(365/Number of days paid early) - 1
Here, the discount percentage is 2%, and the number of days paid early is 5 (30-25).
Plugging in the values, we get:
Effective Annual Cost = [(1+ 0.02)/(1- 0.02)]^(365/5) - 1
= (1.02/0.98)^(73) - 1
= 1.635 - 1
= 0.635 or 63.5%
Therefore, the best choice is B.
Learning Objectives
- Acquire knowledge about the effects of skipping discounts on trade credit arrangements.
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