A firm has purchased raw materials on credit, and has been given the payment ter

Question

A firm has purchased raw materials on credit, and has been given the payment terms as 3/10; net 40. The firm has calculated the interest rate of waiting until 40 days to pay the credit to be 44.86%. How should the firm view this interest rate?

The average interest rate on their portfolio of marketable securities The effective borrowing rate should they decide to take the discount The effective borrowing rate should they decide not to take the discount The amount of the discount, that is - a discount of $55.14 for each $100 of credit The amount of the discount - that is - a discount of $44.86 for each $100 of credit

Explanation / Answer

Using Arithmetic Method, Interest Rate calculation =3/(1-0.03)x365/(40-10) =3/0.97x365/30 =37.62%

Using Geometric Method, Effective Rate =(1+ 0.03/(1-0.03))365/30 -1 = 1.4486 -1 =44.86%

The firm should view this rate as reference rate of their short term borrowings. If the borrowing rate is lesser than this rate, the firm should pay within discount period. If the rate of borrowing is higher, the firm should pay preferably on the last day of the credit period.

Hence, option-c is the correct answer.

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