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Chapter 15: Problem 8

a. If a firm buys under terms of \(3 / 15,\) net \(45,\) but actually pays on the 20 th day and still takes the discount, what is the nominal cost of its nonfree trade credit? b. Does it receive more or less credit than it would if it paid within 15 days?

Short Answer

Expert verified
The nominal cost is 37.6%. The firm uses more credit than if it paid within 15 days.

Step by step solution

01

Understanding the Terms

The terms "\(3 / 15,\) net \(45\)" mean that the firm receives a \(3\%\) discount if it pays within 15 days. Otherwise, the full invoice amount is due in \(45\) days.
02

Calculate the Nominal Cost of Missing Discounts

If the firm pays on the 20th day but takes the discount, it effectively uses credit for 5 days (20 - 15). The nominal cost of missing discounts can be calculated using the formula: \[\text{Nominal Cost of Nonfree Trade Credit} = \left(\frac{Discount\,\%}{100\% - Discount\,%} \right) \times \frac{365}{Pay Period - Discount Period}\]Substitute the values: \[\left(\frac{3\%}{100\% - 3\%} \right) \times \frac{365}{45 - 15} = \left(\frac{0.03}{0.97} \right) \times \frac{365}{30}\]Calculate the result.
03

Solve the Calculation

First, calculate \[\frac{0.03}{0.97} = 0.03093\]Next, calculate the second part:\[\frac{365}{30} \approx 12.1667\]Finally, multiply these results:\[0.03093 \times 12.1667 \approx 0.376\ or\ 37.6\%\] So, the nominal cost of nonfree trade credit is 37.6%.
04

Determine Credit Usage

Since the firm is paying on the 20th day and taking the discount, it is using more credit than if it had paid on the 15th day. The additional 5 days of credit reflect this.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Discount Terms
Discount terms are a vital part of trade credit agreements. They determine when a firm can receive a discount for early payment. In the given example, the terms are "3/15, net 45". This implies that the buyer will obtain a 3% discount if they pay the bill within 15 days of receiving the invoice. The "net 45" portion indicates that if they opt not to take the discount, they must pay the full amount within 45 days.

Understanding these terms can help a firm manage cash flow efficiently. Opting for discounts can be cost-saving if planned wisely. It's crucial to know that any delay beyond the discount period leads to loss of this saving opportunity.
Nominal Cost Calculation
The nominal cost of not adhering to the discount terms represents the effective annual interest rate that the firm incurs by skipping the discount. Calculating this cost helps businesses understand the financial impact of not taking advantage of discounts.

In our example, if the firm pays on the 20th day while still pretending to take the discount, they are technically using nonfree credit for 5 additional days. This non-adherence to the discount terms incurs a cost. The formula used to calculate this is:

  • Discount Percentage: Represented as a decimal.
  • Annual Days: Typically 365 days.
  • Pay Period: Number of days until full payment is due.
  • Discount Period: Number of days to avail of the discount.
The formula is:

\[\left(\frac{Discount\,\%}{100\% - Discount\,\%} \right) \times \frac{365}{Pay\,Period - Discount\,Period} \approx 37.6\%\]
Through this, firms realize how expensive it can be to postpone payments.
Credit Utilization
Credit utilization in the context of trade credit is about how effectively a business uses the credit terms extended by suppliers. Taking the example, the firm paid on the 20th day but took the discount, using an additional 5 days of credit beyond the discount period.

Effective credit utilization means optimizing cash flow, ensuring the least cost for borrowed time between receiving goods/services and making payments. Companies should aim to take advantage of discount opportunities, effectively reduce interest burdens, and manage financial obligations within the offered credit terms.
  • Early payment can reduce costs significantly.
  • Extra use of credit should be carefully evaluated against potential cash flow constraints.
  • Understanding, planning, and managing credit terms can lead to long-term financial health.
Efficient credit utilization aligns with overall business profitability and operational sustainability.

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Most popular questions from this chapter

The Zocco Corporation has an inventory conversion period of 75 days, a receivables collection period of 38 days, and a payables deferral period of 30 days. a. What is the length of the firm's cash conversion cycle? b. If Zocco's annual sales are \(\$ 3,421,875\) and all sales are on credit, what is the firm's investment in accounts receivable? c. How many times per year does Zocco turn over its inventory?

The text identifies three principal components that jointly comprise the cash conversion cycle. The cash conversion cycle is defined as the average length of time a dollar is tied up in current assets, and it is determined by the interaction between the inventory conversion period, receivables collection period, and the payables deferral period. Ideally, a company wants to minimize the cash conversion cycle as much as possible. In some circumstances, a firm has a comparative advantage in working capital management because of the nature of its business. This cyber-problem looks at two competing booksellers. Barnes and Noble Inc. is a hybrid between the traditional brick and mortar retailer and the Internet retailer. However, approximately 85 percent of its revenues are generated in the traditional retail setting, which will lead us to consider it a traditional retail firm. Amazon.com, on the other hand, represents the new wave of Internet retailing. The success of Amazon.com has spawned the flood of specialty retailing into the Internet marketplace. We will look at the cash conversion cycles of these companies and their implications. For this cyberproblem, you will be accessing information from the web sites for Barnes and Noble Inc. and Amazon.com at http://www.shareholder.com/bks and http://www.amazon.com, respectively. a. Go to Barnes and Noble's web site, and click on "Annuals." Now that you are in the annual report gallery, click on "1999 Annual Report. (HTML version)" to view the 1999 annual report. Click on "1999 Financial Review" and then click on "Consolidated statements of Operations." From the income statement, write down the annual sales and cost of goods sold for \(1999 .\) Assuming a 365 -day year, what are the average daily sales and purchases for Barnes and Noble Inc.? b. Go back one screen and click on "Consolidated Balance Sheets." Write down the 1999 balances shown for the firm's inventories, accounts receivable, and accounts payable. Using this information plus that from part a, calculate its inventory conversion period, receivables collection period, and payables deferral period. c. What is Barnes and Noble's cash conversion cycle? d. Now, access Amazon's web site. Scroll to the bottom of the page, and click on "About Amazon.com." Next, click on "Investor Relations," and then click on "Annual Reports \& Financial Documents." Click on 1999 Annual Report on Form \(10-\mathrm{K},\) and scroll down until you see Amazon's Consolidated Statement of Operations. Find the annual sales and cost of goods sold. Again, assuming a 365 day year, calculate the average daily sales and purchases for Amazon. e. Scroll up a page until you see Amazon's Consolidated Balance Sheets. Record 1999 balances for inventories, accounts receivable, and accounts payable. Use this information to calculate Amazon's inventory conversion period, receivables collection period, and payables deferral period. f. Calculate Amazon's cash conversion cycle. g. Compare the cash conversion cycles of Barnes and Noble and Amazon. What factors are responsible for these differences? Are these differences firm specific, or are they consequences of the nature of the businesses in which these firms operate? h. Interpret your results. Explain in words what the cash conversion cycles you calculated mean for these companies.

A chain of appliance stores, APP Corporation, purchases inventory with a net price of \(\$ 500,000\) each day. The company purchases the inventory under the credit terms of \(2 / 15,\) net \(40 .\) APP always takes the discount, but takes the full 15 days to pay its bills. What is the average accounts payable for APP?

The Rentz Corporation is attempting to determine the optimal level of current assets for the coming year. Management expects sales to increase to approximately \(\$ 2\) million as a result of an asset expansion presently being undertaken. Fixed assets total \(\$ 1\) million, and the firm wishes to maintain a 60 percent debt ratio. Rentz's interest cost is currently 8 percent on both short-term and longer-term debt (which the firm uses in its permanent structure). Three alternatives regarding the projected current asset level are available to the firm: (1) a tight policy requiring current assets of only 45 percent of projected sales, (2) a moderate policy of 50 percent of sales in current assets, and (3) a relaxed policy requiring current assets of 60 percent of sales. The firm expects to generate earnings before interest and taxes at a rate of 12 percent on total sales. a. What is the expected return on equity under each current asset level? (Assume a 40 percent effective federal-plus-state tax rate. b. In this problem, we have assumed that the level of expected sales is independent of current asset policy. Is this a valid assumption? c. How would the overall riskiness of the firm vary under each policy?

The Thompson Corporation projects an increase in sales from \(\$ 1.5\) million to \(\$ 2\) million, but it needs an additional \(\$ 300,000\) of current assets to support this expansion. Thompson can finance the expansion by no longer taking discounts, thus increasing accounts payable. Thompson purchases under terms of \(2 / 10,\) net \(30,\) but it can delay payment for an additional 35 days \(-\) paying in 65 days and thus becoming 35 days past due without a penalty because of its suppliers' current excess capacity problems. What is the effective, or equivalent, annual cost of the trade credit?
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