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

Mehta Industries has annual purchases of Rs 36,00,000 (360-day year, evenly spread). Suppliers allow 2/10, net 40. The firm can borrow from its bank at 15% p.a. If it takes the discount, it must borrow the net amount for the extra days. Which decision is correct?

The firm should take the discount. Forgoing 2/10 net 40 costs about 24.49% annually, calculated as 2/98 times 360/30, which is higher than the 15% bank borrowing rate, so financing early payment with a bank loan is cheaper.

  1. ATake the discount, since the cost of forgoing it (about 24.49%) exceeds 15%Correct
  2. BForgo the discount, since the cost of forgoing it (about 24.49%) exceeds 15%
  3. CForgo the discount, since the cost of forgoing it (about 12.24%) is below 15%
  4. DTake the discount, since the cost of forgoing it (about 36.73%) is below 15%

Explanation

Cost of forgoing = (2/98) x (360/30) = 0.020408 x 12 = 24.49%. Since this exceeds the 15% bank rate, borrowing to pay early on day 10 is cheaper, so the discount should be taken. The second option reverses the logic.

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