Principles of Managerial Finance

638 PART 5 Short-Term Financial Decisions

Firm

Makes

$1,000

Purchase

Feb. 27

Credit

Period

Begins

Mar. 1

Mar. 10

Cost of Additional 20 Days = $1,000 – $980 = $20

Cash Discount

Period Ends;

Pay $980

Mar. 30

Credit Period

Ends;

Pay $1,000

FIGURE 15.1

Payment Options
Payment options for
Lawrence Industries

1. Equation 15.1 and the related discussions are based on the assumption that only one discount is offered. In the
   event that multiple discounts are offered, calculation of the cost of giving up the discount must be made for each
   alternative.


2. This example assumes that Lawrence Industries gives up only one discount during the year, which costs it 2.04%
   for 20 days (that is, 2%98%) or 36.73% when annualized. However, if Lawrence Industries continuallygives up
   the 2% cash discounts, the effect of compounding will cause the annualized cost to rise to 43.84%:
   Annualized cost when discounts
   are continually given up ^1  

360/N

 1 (15.1a)

 1  

360/20

100%2%2%  1  (^4)  (^3) . (^8)  4 %
CD
100%CD
Lawrence Industries. The annual percentage cost of giving up the cash discount
can be calculated using Equation 15.1:^1
Cost of giving up cash discount(15.1)
where
CDstated cash discount in percentage terms
Nnumber of days that payment can be delayed by giving up the cash
discount
Substituting the values for CD(2%) and N(20 days) into Equation 15.1 results
in an annualized cost of giving up the cash discount of 36.73% [(2%98%)
(36020)]. A 360-day year is assumed.^2
A simple way toapproximatethe cost of giving up a cash discount is to use
the stated cash discount percentage,CD, in place of the first term of Equation
15.1:
Approximate cost of giving up cash discount CD (15.2)
360

N
^360
N
CD

100%CD