Prairie Manufacturing has four possible suppliers, all of which offer different
ID: 2778815 • Letter: P
Question
Prairie Manufacturing has four possible suppliers, all of which offer different credit terms. Except for the differences in credit terms, their products and services are virtually identical. The credit terms offered by these suppliers are shown in the following table. (Note: Assume a 365-day year.)
Supplier - Credit terms
J - 1/5 net 30 EOM
K - 2/20 net 80 EOM
L - 1/15 net 60 EOM
M - 3/10 net 90 EOM
a. Calculate the approximate cost of giving up the cash discount from each supplier.
b. If the firm needs short-term funds, which are currently available from its commercial bank at 9%, and if each of the suppliers is viewed separately, which, if any, of the suppliers’ cash discounts should the firm give up? Explain why.
c. Now assume that the firm could stretch by 30 days its accounts payable (net period only) from supplier M. What impact, if any, would that have on your answer in part b relative to this supplier?
Explanation / Answer
Answer (a)
Approximate cost of giving up the discount
J – 33.92%
K - 27.55%
L - 17.61%
M – 31.50%
Answer (B)
If the funds are available from commercial bank at 9%, then the firm can give up discounts of L as the benefit is the lowest in his case.
Answer (C)
If the firm is able to stretch the net credit period by 30 days for supplier M, the decision is still the same as b above.
woking
J - 1/5 net 30 EOM - discount rate 1%, period = 5 days, total credit period = 30 days
Cost of credit = [{(1+discount rate)/(1-discount rate)}^(365/days beyond discount) – 1)]
= [{(1+0.01)/(1-0.01)}^(365/30-5) – 1)]
= [{(1.01)/(0.99)}^(365/25) – 1)]
= [{(1.01)/(0.99)}^(14.6) – 1)]
= 1.020202^14.6 – 1
= 1.339116 – 1 = 0.339116 or 33.92% (rounded off)
K – 2/20 net 80 EOM
Cost of credit = [{(1+0.02)/(1-0.02)}^(365/80-20) – 1)]
= [{1.02/0.98)}^(365/60) – 1)]
= [1.0408163^(6.08333) – 1]
= 1.2755347 – 1
= 0.2755347 or 27.55% (rounded off)
L – 1/15 net 60 EOM
Cost of credit = [{(1+0.01)/(1-0.01)}^(365/60-15) – 1)]
= [{(1.01)/(0.99)}^(365/45) – 1)]
= (1.020202^8.1111) – 1
= 1.1761277 – 1
= 0.1761277 or 17.61% (rounded off)
M – 3/10 net 90 EOM
Cost of credit = [{(1+0.03)/(1-0.03)}^(365/90-10) – 1)]
= [(1.03/0.97)^(365/80) -1]
= 1.06185567^4.5625 – 1
= 1.314994 – 1
= 0.314994 or 31.50%
Net benefit to the firm if they avail loan from commercial bank and avail the discount from the creditor
J – 33.92 - 9%/365 * 25 = 33.92 – 0.61 = 33.31%
K – 27.55% - 9%/365*60 =36.5 – 1.47 = 26.08%
L – 17.61 – 9/365 * 45 = 17.61 – 1.11 = 16.5%
M = 31.5 - 9/365 * 80 = 31.5 – 1.972 = 29.527%
Based on the above the firm could give up the discount from L as the net benefit is the lowest in their case.
If the firm is able to stretch the net credit period by 30 days for supplier M, then cost of credit for M would be
Cost of credit = [{(1+0.03)/(1-0.03)}^(365/90+30-10) – 1)]
= (1.03/0.97)^(365/110) – 1
= 1.06185567^3.3181818 – 1
= 1.2203659 – 1
= 0.2203659 or 22.04%
Benefit = 22.04 – 9/365 * 110 = 22.04 – 2.712 = 19.328%
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