Question

You have looked at the credit policy offered by your competitors and have determined that the industry standard credit policy is 1/10, net 45. The discount will begin to be offered on the first day of the year. You want to examine how this credit policy would affect the cash budget and short-term financial plan. If this credit policy is implemented, you believe that 60 percent of customers will take advantage of the credit offer and the accounts receivable period will be 24 days. Rework the cash budget and short-term financial plan under the new credit policy and a target cash balance of $80,000. What interest rate are you effectively offering customers?

Answer 1

Credits Terms: 1% discount if Sales paid within 10 days, else amount is due in 45 days.

Under this credit policy, you would get 99% of the amount back in 10 days by forgoing 1% of the amount.

Interest rate for each credit cycle = 1% / 99% = 1.01%

Since there are (45 - 10 days) or 35 days when you can invest the collected sales in the business and earn returns. The interest rate completes one cycle in total 45 days, before another cycle for A/R collection starts. For that extra period, customers are missing out on the returns while you would be earning the returns. Therefore, this interest rate will be charged 365 / 35 times in a year.

Effective Annual Rate offered to customers = (1 + 1% / 99%)^365/35 - 1

Effective Annual Rate offered to customers = 1.1105 - 1 = 11.05%

Hence, The effective annual rate you are offering to the customers is 11.05%