Question

Explain the trade credit facility provided by some companies to their customers that allow them to manage their day-to-day liquidity situation and calculate the opportunity cost of an invoice that specifies the following conditions, as shown below (a. – c.): a) conditions: 1.25/10, n/30. b) conditions: 1.25/10, n/60. c) conditions: 1.5/10, n/60.

Answer 1

Credit facility is provided by most firms to their clients. For that, the firms formulate a credit policy, which prescribes how to evaluate credit, how to fix credit limits, credit period, cash discount, collection policy, etc.

If there is a cash discount for early payment, the cost of not taking the discount is to be ascertained and the discount should be foregone, only if, the cost of borrowings [to pay withing the cash discount period] is more than the cost of not taking the discount.

The cost of not taking the discount [opportunity cost] is calculated in the table below for all the three options:

a]	Cost of not taking discount = (1.25/98.75)*(365/20) =	23.10%
b]	Cost of not taking discount = (1.25/98.75)*(365/50) =	9.24%
c]	Cost of not taking discount = (1.5/98.5)*(365/50) =	11.12%