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Cash sales refer to transactions where payment is made immediately at the time of purchase. This means there is no waiting period for the seller to receive their money. Cash sales ensure that the company has instant liquidity, which is vital for day-to-day operations.

When a business decides to offer credit instead of cash sales, it alters the immediate cash flow. The firm has to wait for the payment, which means it can affect the working capital available for other business activities.

• For businesses with cash sales only, risks associated with outstanding debts are minimized.
• There's an instant inflow of cash, which can be directly reinvested or used to meet operational expenses.
• Cash sales generally incur fewer transaction costs compared to credit sales.

This immediate transaction nature reduces financing and administrative costs associated with managing accounts receivables.

Interest calculation becomes crucial when offering credit sales, as it determines the cost of borrowing to cover the money tied up in accounts receivable. In the exercise, the bank charges a nominal annual interest rate of 12% compounded daily.

To comprehend the daily interest, the nominal rate is divided by the number of days in the year (360 days in this case). This results in a daily interest rate of:

• \( r_d = \frac{0.12}{360} \)

This calculation gives you the rate of interest applied per day, crucial for determining how much the delayed payments will cost over time.

Next, we apply this daily rate to understand the growth of a single dollar (\( P = 1 \)) over the period of 90 days using the compound interest formula. This formula accounts for the compounding effect, where today's interest earns more interest in subsequent days.

Price adjustment is necessary to cover the costs incurred due to offering credit. Since customers will wait the full 90 days to pay, your firm needs to calculate the interest cost as detailed before and decide how much to increase prices.

The interest cost is determined by finding the future value of a dollar after 90 days and then subtracting the original dollar. This difference indicates the interest accrued over the credit period. Using the formula: \[ FV = 1 \times (1 + \frac{0.12}{360})^{90} \] leads to finding the future value. The interest cost is just \( FV - 1 \).

Now, convert this cost into a percentage increase. By multiplying the difference by 100, you format it as a percentage, which guides the needed price adjustment. Business then rounds this number to find the percentage increase required in product prices to offset the bank interest expense from offering credit terms.

The time value of money is a core concept in finance, emphasizing that money available today is worth more than the same amount in the future due to its potential earning capacity.

When a firm considers offering credit, it must account for this principle because receiving payments later diminishes the funds' immediate capacity to earn or be used. The firm should understand that money expected after a certain period, like 90 days, will have a different value than the present value, mainly due to inflation, opportunity costs, and interest rate implications.

In the provided exercise, understanding the time value of money means realizing the cost of waiting for payments and the necessity to adjust prices to cover this expenditure. Businesses adjust their pricing strategy to ensure they don't lose out financially when converting cash sales into credit sales. This adjustment helps maintain their financial health while accommodating their customer's need for deferred payment.