Question

P6-9 (L02,4) (Analysis of Business Problems) James Kirk is a financial executive with McDowell Enterprises. Although James Kirk has not had any formal training in finance or accounting, he has a “good sense” for numbers and has helped the company grow from a very small company ($500,000 sales) to a large operation ($45 million in sales). With the business growing steadily, however, the company needs to make a number of difficult financial decisions in which James Kirk feels a little “over his head.” He therefore has decided to hire a new employee with “numbers” expertise to help him. As a basis for determining whom to employ, he has decided to ask each prospective employee to prepare answers to questions relating to the following situations he has encountered recently. Here are the questions.

1. (c) The company has always followed the policy to take any cash discounts on goods purchased. Recently, the company purchased a large amount of raw materials at a price of $800,000 with terms 1/10, n/30 on which it took the discount.

Problems 309

McDowell has recently estimated its cost of funds at 10%. Should McDowell continue this policy of always taking the cash discount?

Answer 1

Let's evaluate both the situations and see the attached benefits :

If the cash discount is availed,

Benefit derived will be 8% of INR 8,00,000 which is INR 8,000

Funds required will be INR 8,00,000 - INR 8,000 = INR 7,92,000

Cost of funds will be 7,92,000 * 10% * 30/365 = 6,510

Net Benefit derived = 8,000 - 6,510 = 1490

If the cash discount is not availed,

Amount of discount lost - INR 8,000

Cost of funds saved - 8,00,000 * 10% * 30/365 = 5,260

Net Benefit derived = 5,260 - 8,000 = (2,739)

(Note: The solution is given assuming the cash payment is done on the 1st day of the amount due. The same can be solved assuming the cash payment is done on 10th day and calculating the cost of funds for 20 days instead of 30 days.)

From the above evaluation, it is clear that availing cash discount is beneficial to the Company.