CFAI Cost of Trade Credit intuitive explanation

Hi all,

Hopefully this helps some people. I found the CFAI formula for the cost of trade credit really non-intuitive, unhelpful and a largely useless exercise in memorisation. As such, I prefer to start the process using the present/future value formula (FV = PV*(1+r)^n) to minimise memorisation (which the CFAI formula is a derivation of)

Assume you have a credit term of 1/10 net 30. If we paid on day 10, we would get a 1% discount, at 10-30 days we pay the full amount. So, to calculate the cost of trade credit we can say that our 99% payment ‘turned into’ 100% by virtue of the trade credit (after the discount period). Mathematically FV = 1, PV = 0.99, n = 10/365 [as we are annualising the rate and are only concerned with the period AFTER the discount period, as the prior period is free], r = variable to solve

1 = 0.99*(1+r)^(10/365)
1/0.99=(1+r)^(10/365)
(1/0.99)^(365/10)=1+r
(1/0.99)^(365/10)-1=r
r= 44.3%

Hope helpful to some.

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