Question

Problem 16-10
Effective Cost of Trade Credit

The D.J. Masson Corporation needs to raise $700,000 for 1 year to supply working capital to a new store. Masson buys from its suppliers on terms of 2/10, net 90, and it currently pays on the 10th day and takes discounts. However, it could forgo the discounts, pay on the 90th day, and thereby obtain the needed $700,000 in the form of costly trade credit. What is the effective annual interest rate of this trade credit? Assume 365 days in year for your calculations. Do not round intermediate calculations. Round your answer to two decimal places.

%

Answer 1

If it would have taken the discount then the value of the discount would have been $700,000*2% = $14000

So the reduced balance it would have been paying under discount methodology would be $700,000-$14,000 = $686,000

So the Effective Annual interest rate of the trade credit would be; (since the interest remains unavailable with the balance number of days remaining being 80days)

[{1 + (Interest/ Reduced Payment) ^ (365/80)}-1]*100

[{(1+ 0.02041) ^ (4.5625)-1]*100 = 9.655%

Hence the EAR of the trade credit would be 9.655%