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CA Intermediate · Financial Management and Strategic Management · Management of Payables (Creditors)

Gupta Ltd is offered a cash discount of 1.5/15, net 45 by its supplier. Its bank overdraft costs 18% p.a. Using a 360-day year and the simple formula, which decision is correct?

Gupta Ltd should take the discount. The implicit cost of forgoing it is 1.5/98.5 times 360/30, about 18.27%, which is higher than the 18% overdraft rate, so borrowing from the bank to pay early is cheaper.

  1. ATake the discount, since cost of forgoing it is about 18.27% which exceeds 18%Correct
  2. BForgo the discount, since cost of forgoing it is about 18.27% which exceeds 18%
  3. CTake the discount, since cost of forgoing it is about 9.14%
  4. DForgo the discount, since cost of forgoing it is about 36.55%

Explanation

Cost of forgoing = [1.5/98.5] x [360/30] = 1.5228% x 12 = 18.27%. This exceeds the overdraft rate of 18%, so it is cheaper to borrow from the bank and pay early to take the discount. Forgoing would mean paying the dearer 18.27% implicit rate.

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