Langley Clinics, Inc., buys $400,000 in medical supplies each year (at gross pri
ID: 2763173 • Letter: L
Question
Langley Clinics, Inc., buys $400,000 in medical supplies each year (at gross prices) from its major supplier, Consolidated Services, which offers Langley terms of 2.5/10, net 45. Currently, Langley is paying the supplier the full amount due on day 45, but it is considering taking the discount, paying on Day 10, and replacing the trade credit with a bank loan that has a 10 percent annual cost.
a. What is the amount of free trade credit that Langley obtains from Consolidated Services? (Assume 360 days per year throughout this problem.)
b. What is the amount of costly trade credit?
c. What is the approximate annual cost of the costly trade credit?
d. Should Langley replace its trade credit with the bank loan? Explain your answer. e. If the bank loan is used, how much of the trade credit should be replaced?
Explanation / Answer
a. Langley buys $400,000 (gross) in medical supplies a year from Consolidated.
The net purchases (the true cost of the supplies) is only 0.975 x $400,000 = $390,000 because they can be bought at a 2.5 percent discount when payment is made within 10 days.
On a daily basis, Langley purchases $390,000 / 360 = $1,083.33. If Langley takes the free credit and pays on Day 10, its payables from Consolidated would total 10 x $1,083.33 = $10,833.33, which is the amount of free credit.
b. If Langley pays after 45 days, its accounts payable will increase to 45 x $1,083.33 = $48,750. Thus, the amount of costly trade credit is,
Total trade credit – Free trade credit = $48,750 – $10,833.33 = $37,916.67.
c. Approximate percentage cost:
$37,916.67
2.5 360
= 0.264 = 26.4%.
d. If Langley can obtain a bank loan for less than 26.4 percent cost, including interest cost and fees, it should replace the costly credit ($37,916.67) with a bank loan.
e.As i explained in (d) only the costly trade credit should be replaced. Langley should always take the $10,033.33 of free trade credit.
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