Firm A is considering to extend trade credits to customers with X/5, net 60, bas

Question

Firm A is considering to extend trade credits to customers with X/5, net 60, based on the invoice date, but the firm is not sure how large the discount (X) should be. Customers, by not taking the cash discount, could actually use the payable as a source of internal financing. Currently, customers could obtain a line of creidt at an annual interest rate of 14.14%. Which of the following statements is Most Correct? Use 360 days in a year.

a. If X=14.14%, customers would be indifferent between not taking the cash discount and obtaining the line of credit.

b. If X>14.14%, customers would be less likkely to take the cas discount

c. If X<2%, customers are more likely not taking the cash discount

d. If X<2%, customers are morelikely to obtain the line of credit.

e. None of the above

please provide the solution

Explanation / Answer

Ans -

c. If X<2%, customers are more likely not taking the cash discount

Here we first see what does discount of 2% would mean to customer. Suppose the AP(invoice amount ) is 1000 and at the current situation customer is paying it at N60. So customer is using $1000 for 60 days and Finally paying $1000 at the end of 60 days.

Now lets see how much Customer would save because of Discount @ 2% & how much extra he pays assuming that the amount paid paid by him in 5 days is refinanced by some other sources at 14.14% as he has given up the opportunity for using the credit limit for 55 days

Thus we see that at 2% discount customer would save less and pay more interest for those 55 days. So ultimately Customer at the end of 60 days would pay 980+21.60 = $1001.60 . So So a Discount of less then 2% would not be accepted by customer for early payment . If the Discount is 14.14 there is no doubt it will be favourabel to customer as a discount of 2.16% or above is beneficial to customer

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