Question

Generally, it is a sound business practice to take advantage of cash discounts. the money saved by paying invoices promptly is free to be used elsewhere. conversely, there is an implicit (opportunity) cost of foregoing a cash discount. by forgoing a cash discount, the small business owner is, in effect, paying an annual interest rate to retain the use of the discounted amount for the remainder of the credit period.

For example, assume that Jill anticipates she will receive invoices for $500 from the vendors offering cash discounts of 3/10, net 45.

a) how much will Jill save by paying within the discount period?

b) what will it cost Jill to retain the use of credit for 45 days?

c) what is the annual interest rate of the "loan" (ie. what is the annual rate of 3/10, net 45)?

Answer 1

Answer: a. $485

b. $15

c. 32.28%

Step-by-step explanation:

a. how much will Jill save by paying within the discount period?

3% × $500 = 3/100 × $500 = 0.03 × $500 = $15

The amount saved will be:

= $500 - $15.

= $485

b) what will it cost Jill to retain the use of credit for 45 days?

This will be:

= 3% × $500

= 3/100 × $500

= 0.03 × $500

= $15

c) what is the annual interest rate of the "loan" (ie. what is the annual rate of 3/10, net 45)?

c) The annual interest will be calculated using:

= P x R x T

where,

I = interest = $15

P = principal = $485

R= rate of interest = Unknown

T= time factor = 15/365 = 0.0958

Then, annual Interest rate will be:

R = 15/ (485 x 0.0958)

R = 32.28%

Annual Interest rate is 32.28%