2. Justso Ltd buys on terms 1.5/10 , net 30 days . It does not take discounts ,

Question

2. Justso Ltd buys on terms 1.5/10 , net 30 days . It does not take discounts , but it typically pays 20 days after the invoice date , instead of waiting until Day 30 . Justus can borrow from the bank at a rate of 18% per annum.

(a)If Justso is not taking discounts and is paying on Day 20 , what is the effective annual cost of the firm’s current practice , using a 360-day year?

(b)Please advise Justso Ltd on its cheapest course of action if the firm’s suppliers do not take action on outstanding accounts unless they remain unpaid 80 days after the date of the invoice . Please back your advice up with appropriate calculations .

(c)Please advies Justso Ltd on its cheapest course of action if the firm’s suppliers take action on outstanding accounts when they remain unpaid at the start of the 31st day after the date if the invoice . pLease back your advice up with appropriate calculations.

Explanation / Answer

a) If jutso pays on the 10th day it need pay only 0.985 per dollar value of the invoice. Instead it is paying $1 on the 20th day.

So 0.015$ can be considered as the interest on 0.985 for 10 days.

the rate of interest for the 10 days = 0.015/.985 = 0.0152

effective annual cost = 0.0152*360/10 = 0.5482 = 54.82%

b) If justso can delay payment upto 80 days without any adverse consequences, the effective annual rate of interest will be 0.0152*360/70 = 0.0783 = 7.83%. The assumption is that jutso is paying only on the 80th day.

If jutso's cost of funds is less than 7.83% pa, it should avail of the discount. Here, as the cost of borrwing of Justso is 18% it should not avail the discount.

C) if justo has to pay on the 31st day to avoid action, the effective annual interest rate would be

0.0152*360/20 = 0.2736 = 27.36%.

As justso's cost of borrowing is only 18% when compared to the effective interest rate 0f 27.36% in the discount term, justso should avail of the discount and pay on the 10th day.

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