Principles of Managerial Finance

CHAPTER 15 Current Liabilities Management 639

TABLE 15.1 Cash Discounts and

Associated Costs for

Mason Products

Approximate

cost of giving up

Supplier Credit terms a cash discount

A 2/10 net 30 EOM 36.0%

B 1/10 net 55 EOM 8.0

C 3/20 net 70 EOM 21.6

D 4/10 net 60 EOM 28.8

The smaller the cash discount, the closer the approximation to the actual cost of

giving it up. Using this approximation, the cost of giving up the cash discount for

Lawrence Industries is 36% [2%(36020)].

Using the Cost of Giving Up a Cash Discount in Decision Making The

financial manager must determine whether it is advisable to take a cash discount.

Financial managers must remember that taking cash discounts may represent an

important source of additional profitability.

EXAMPLE Mason Products, a large building-supply company, has four possible suppliers,
each offering different credit terms. Otherwise, their products and services are
identical. Table 15.1 presents the credit terms offered by suppliers A, B, C, and D
and the cost of giving up the cash discounts in each transaction. The approxima-
tion method of calculating the cost of giving up a cash discount (Equation 15.2)
has been used. The cost of giving up the cash discount from supplier A is 36%;
from supplier B, 8%; from supplier C, 21.6%; and from supplier D, 28.8%.
If the firm needs short-term funds, which it can borrow from its bank at an
interest rate of 13%, and if each of the suppliers is viewed separately,which (if
any) of the suppliers’ cash discounts will the firm give up? In dealing with sup-
plier A, the firm takes the cash discount, because the cost of giving it up is 36%,
and then borrows the funds it requires from its bank at 13% interest. With sup-
plier B, the firm would do better to give up the cash discount, because the cost of
this action is less than the cost of borrowing money from the bank (8% versus
13%). With either supplier C or supplier D, the firm should take the cash dis-
count, because in both cases the cost of giving up the discount is greater than the
13% cost of borrowing from the bank.

The example shows that the cost of giving up a cash discount is relevant

when one is evaluating a single supplier’s credit terms in light of certain bank

borrowing costs.However, other factors relative to payment strategies may also

need to be considered. For example, some firms, particularly small firms and

poorly managed firms, routinely give up alldiscounts because they either lack

alternative sources of unsecured short-term financing or fail to recognize the

implicit costs of their actions.