Question

1 The implied annual interest rate formula is: (365 days X [Credit period - Discount period]) X Cash discount rate.
For terms of 2 10, n 30, missing the 2% discount for an additional 20 days is equal to an annual interest rate of 36.5%, computed as (365 days X [30 days - 10 days]) X 2% discount rate. "Favorable purchase discounts are those with implied annual interest rates that exceed the purchaser’s annual rate for borrowing money."

I am having hard time understanding the last sentence. If Implied Annual Interest rates exceeds the purchases' annual rate for borrowing money, than the purchase discount is favorable!

If the annual rate for borrowing money is 5% and Implied Annual Interest rate is 10% , and if the purchaser doesn't make payment in the discount period, than purchaser would rather borrow money and pay for it in the discount period. And, if the Implied annurate interest rate is 5% , but the annual rate to borrow money is 10% , the buyer/purchaser would rather wait out until the last day to pay for the marchadise purchased, given the purchaser is unable to pay for marchadise in the discount period.

Am I right?

Answer 1

Availing the purchase discount within the discount period would require payment of money by the company. Now if we assume that the company does not have the requisite cash to pay off, thereby not being able to avail the discount, the company must borrow money if it wants to pay off and avail the discount. If the discount rate is greater than the borrowings rate, then availing the discount would make sense because the benefit generated by the discount would outweigh the cost of borrowing. However, in a reverse situation (when the discount rate is less than borrowing rate, thereby making discount benefit less than borrowing cost) it would make more sense to wait out the discount period and then make a payment so as to avoid a borrowings backed discounted pay off.