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

Sharma Ltd buys on '3/10, net 40'. Its bank charges 20% p.a. It can pay on day 10 by borrowing, or stretch payment beyond day 40 to day 70 without penalty (the supplier tolerates it). Using a 360-day year and the simple formula, which option is best on cost and what is the annualised cost of foregoing the discount if payment is made on day 70?

Sharma should pay on day 70. Foregoing the 3% discount and paying 60 days after the discount period costs (3/97) x (360/60), about 18.6%, which is lower than the 20% bank rate. Stretching is cheaper than borrowing, though paying on day 40 would have cost 37.1%.

  1. APay on day 70; cost of foregoing is about 18.6% which is below the 20% bank rateCorrect
  2. BPay on day 10; cost of foregoing is about 37.1% at day 40, so discount is better than stretching
  3. CPay on day 40; cost is 37.1% so borrow from bank
  4. DPay on day 10; cost of foregoing at day 70 is about 18.6%, so discount is taken

Explanation

At day 70 the cost = (3/97) x (360/60) = 0.030928 x 6 = 18.56%, about 18.6%, below the 20% bank rate. So stretching to day 70 is cheaper than borrowing to take the discount. At day 40 the cost would be (3/97) x (360/30) = 37.1%, which exceeds 20%, so paying on day 40 is worse than paying early. Option D reaches the right figure but the wrong decision.

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