Cost of trade credit

CFA Level I Corporate Finance
#1

All,

I am studying Account Receivables/ Payables chapter. I am not sure why Cost of trade credit = {1 + ( %discount/1-%discount)}^(365/days past discount).

My intuition is going against this formula. Hence, something is missing in my understanding. Here’s what I am thinking.

Let’s say Terms are 2/10 net 60. Therefore, I will get 2% discount if I pay outstanding amount within 10 days, and 0% discount if I pay the outstanding amount within 60 days but greater than 10 days.

Let’s assume that $100 is due. Hence, within 10 days, I will earn $2 interest. I can also think of this as $2 = cost of not paying outstanding amount in the first 10 days. In other words, it’s the cost of paying $100 between 11th and 60th day. Therefore, the cost = 2/100 for 50 days. Now this could be easily annualized using the classic formula :

(1+2%)^(365/50) — The interest portion in this formula is very different from the actual formula. I am not sure why (1-%discount) is in the denominator.

Can someone please help me? I would really appreciate your help. Thanks in advance.

Best regards

#2

Actually, what you have is $98 that is due within 10 days; if you don’t pay within 10 days, they’ll charge you $2 interest, and you have 50 days to pay that; therefore, the cost is 2/98 for 50 days, not 2/100 for 50 days.

That is exactly what that formula is doing:

(1 + 2%/98%)^(365/50).

1 Like
#3

Thanks S2000magician!

#4

My pleasure.