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

Kaveri Traders buys goods on terms '1/15, net 60' and can borrow from a bank at 10% p.a. (360-day year, simple basis). Which decision is financially correct?

Forgoing the discount costs about 8.08% a year (1/99 x 360/45). That is lower than the 10% bank rate, so the firm should forgo the discount and pay on day 60, since early payment financed by the bank would cost more than it saves.

  1. ATake the discount, because the cost of forgoing it is about 8.08%, above the bank rate
  2. BForgo the discount, because the cost of forgoing it is about 8.08%, below the bank rateCorrect
  3. CTake the discount, because the cost of forgoing it is about 10.10%
  4. DForgo the discount, because the cost of forgoing it is about 16.16%

Explanation

Cost of forgoing = [1/99] x [360/(60-15)] = 0.010101 x 8 = 8.08%. Since 8.08% is below the 10% bank rate, trade credit is cheaper than borrowing, so the discount should not be taken. Taking it would require funding at 10% to save only 8.08%.

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