CMA Intermediate · Financial Management and Business Data Analytics · Payable Management
Rao Engineering Ltd has annual purchases of ₹7,20,000 on terms '1/10, net 30'. Its bank overdraft costs 15% p.a. (360-day year). Which action is financially best, and why?
The firm should take the discount. Forgoing 1/10 net 30 costs (1/99) x (360/20) = 18.18% annually, which is higher than the 15% overdraft rate, so borrowing to pay early saves money.
- ATake the discount, because the cost of forgoing it is about 18.18% which exceeds 15%Correct
- BForgo the discount, because the credit cost is 1% which is below 15%
- CForgo the discount, because stretching to day 30 costs only 15%
- DTake the discount, because the cost of forgoing it is about 9.09%
Explanation
Cost of forgoing = (1/99) x (360/20) = 0.010101 x 18 = 18.18%. Since this exceeds the 15% overdraft rate, borrowing from the bank to pay on day 10 is cheaper. Treating 1% as the annual cost ignores annualisation.
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