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ACCA Applied Skills · Financial Management · Management of inventories, accounts receivable, accounts payable and cash

Harlow Ltd buys components on terms of 2/10, net 30. It decides to forgo the early settlement discount and pay on day 30. Using the compound method with a 365-day year, what is the approximate annual effective cost of this trade credit?

The annual cost is about 44.6%. Forgoing a 2% discount means paying 2/98, or 2.04%, to borrow for only 20 extra days. Compounding that over 18.25 periods a year gives roughly 44.6%, far above normal bank borrowing costs.

  1. A2.0%
  2. B18.0%
  3. C44.6%Correct
  4. D36.5%

Explanation

Forgoing the discount costs 2/98 = 2.04% for an extra 20 days (30-10). Annual cost = (1/0.98)^(365/20) - 1 = 1.0204^18.25 - 1. ln 1.0204 = 0.0202, x 18.25 = 0.3687, e^0.3687 = 1.446, so 44.6%. The 36.5% option wrongly uses simple interest (2.04% x 18.25 = 37.2%) and 18% uses a wrong period count.

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