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

Kaveri Traders buys goods worth ₹12,00,000 a year on terms '1/15 net 45'. A bank offers a short-term loan at 10% per annum. Taking a 360-day year and the simple formula for cost of forgoing discount, which course is financially better?

Kaveri should borrow at 10% and take the discount. Forgoing a 1% discount with 30 extra days of credit costs about 12.1% a year (1/99 x 360/30), which is higher than the bank's 10% rate, so paying early with borrowed money is cheaper.

  1. AForgo the discount, since the cost of credit is about 12.1%, below the loan rate
  2. BBorrow at 10% and take the discount, since the cost of forgoing it is about 12.1%Correct
  3. CBorrow at 10% and take the discount, since the cost of forgoing it is about 8.1%
  4. DForgo the discount, since the cost of credit is about 8.1%

Explanation

Cost of forgoing = [1/99] x [360/(45-15)] = 0.010101 x 12 = 12.12%. This exceeds the 10% bank rate, so borrowing to pay on day 15 and earn the discount is cheaper. The 8.1% options come from using 45 days of credit period, which is the wrong base for extra days (360/45 = 8).

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