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

Kaveri Industries buys goods on terms 1/15, net 45 (360-day year, ignoring compounding). It can borrow from a bank at 14% per annum. Cost of forgoing the discount is about 12.12%. What should the firm do?

The firm should forgo the discount and pay on day 45. Forgoing costs (1/99) x (360/30), about 12.12%, which is less than the 14% bank rate, so supplier credit is the cheaper source. Borrowing at 14% to earn a 12.12% discount saving would reduce value.

  1. AForgo the discount and pay on day 45, since the cost of 12.12% is below 14%Correct
  2. BTake the discount and pay on day 15, financing it by the bank loan
  3. CPay on day 30, the midpoint of the period
  4. DTake the discount only if the bank rate falls below 6%

Explanation

Cost of forgoing = (1/99) x (360/30) = 12.12%. Bank borrowing costs 14%, which is higher. So it is cheaper to use the supplier's credit and forgo the discount. Taking the discount would mean paying 14% to save 12.12%, which loses money.

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