Principles of Managerial Finance

CHAPTER 15 Current Liabilities Management 637

cost of giving up a cash discount
The implied rate of interest paid
to delay payment of an account
payable for an additional number
of days.

which resulted in average accounts payable of $473,958. Thus the daily accounts

payable generated by MAX was $13,542 ($473,958/35). If MAX were to mail its

payments in 35 days instead of 30, its accounts payable would increase by

$67,710 ($13,5425). As a result, MAX’s cash conversion cycle would decrease

by 5 days, and the firm would reduce its investment in operations by $67,710.

Clearly, if this action did not damage MAX’s credit rating, it would be in the

company’s best interest.

Analyzing Credit Terms

The credit terms that a firm is offered by its suppliers enable it to delay payments

for its purchases. Because the supplier’s cost of having its money tied up in mer-

chandise after it is sold is probably reflected in the purchase price, the purchaser

is already indirectly paying for this benefit. The purchaser should therefore care-

fully analyze credit terms to determine the best trade credit strategy. If a firm is

extended credit terms that include a cash discount, it has two options—to take

the cash discount or to give it up.

Taking the Cash Discount If a firm intends to take a cash discount, it

should pay on the last day of the discount period. There is no cost associated with

taking a cash discount.

EXAMPLE Lawrence Industries, operator of a small chain of video stores, purchased $1,000

worth of merchandise on February 27 from a supplier extending terms of 2/10

net 30 EOM. If the firm takes the cash discount, it must pay $980 [$1,000

(0.02$1,000)] by March 10, thereby saving $20.

Giving Up the Cash Discount If the firm chooses to give up the cash dis-

count, it should pay on the final day of the credit period. There is an implicit cost

associated with giving up a cash discount. The cost of giving up a cash discountis

the implied rate of interest paid to delay payment of an account payable for an

additional number of days. In other words, the amount is the interest being paid

by the firm to keep its money for a number of days. This cost can be illustrated by

a simple example. The example assumes that payment will be made on the last

possible day (either the final day of the cash discount period or the final day of

the credit period).

EXAMPLE In the preceding example, we saw that Lawrence Industries could take the cash

discount on its February 27 purchase by paying $980 on March 10. If Lawrence

gives up the cash discount, payment can be made on March 30. To keep its

money for an extra 20 days, the firm must give up an opportunity to pay $980

for its $1,000 purchase. In other words, it will cost the firm $20 to delay pay-

ment for 20 days. Figure 15.1 shows the payment options that are open to the

company.

To calculate the cost of giving up the cash discount, the true purchase price

must be viewed as the discounted cost of the merchandise,which is $980 for