Question

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 3/10, net 85, and it currently pays on the 10th day and takes discounts. However, it could forgo the discounts, pay on the 85th 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 a 365-day year. Do not round intermediate calculations. Round your answer to two decimal places.

Answer 1

Solution:-

Given, 3/10,the net 85 which means a firm gives its customer 3% discount if they pay within 10 days of the invoice date,otherwise full amount is due within 85days.

Effective annual cost of trade credit = (1+periodic rate)^period/year - 1

Periodic rate = Discount percentage / (100 - Discount percentage)

Periodic rate = 3% /(100-3%)

= 3% / 97%

= 0.030927 or 3.0927%

Period/year = 365 / (days credit is outstanding-discount period)

= 365 / (85-10)

= 365 / 75

= 4.86666

Effective annual rate = (1+0.030927)^4.86666 - 1

= 1.030927^4.86666 - 1

= 1.15978 - 1

= 0.15978 or 15.978%

Therefore the effective annual interest rate of this trade credit is 15.98%