Question

The firm has an average collection period of 34 days. Current practice is to factor all receivables immediately at a discount rate of (1+0.1*4)%. Assume that default is extremely unlikely. What is the effective annual interest rate on this arrangement?

A) 11.39 percent

B) 12.61 percent

C) 13.84 percent

D) 15.08 percent

E) 16.34 percent

Answer 1

Answer is 16.34%

Discount Rate = (1 + 0.1*x)%
Discount Rate = (1 + 0.1*4)%
Discount Rate = 1.40%

Average Collection Period = 34 days

Effective Interest Rate = [1 + Discount Rate / (1 - Discount Rate)]^[365 / Average Collection Period] - 1
Effective Interest Rate = [1 + 0.0140 / (1 - 0.0140)]^[365 / 34] - 1
Effective Interest Rate = [1 + 0.0140 / 0.9860]^[365 / 34] - 1
Effective Interest Rate = 1.014199^10.735294 - 1
Effective Interest Rate = 1.1634 - 1
Effective Interest Rate = 0.1634 or 16.34%