Corporate Finance

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Corporate Finance

Buyer’s Perspective

Suppose the credit term is 2/10 Net 45. The cost of short-term funds for the company is 11 percent. The terms
imply that the buyer can either make payment in 10 days and receive 2 percent discount, or pay within 45
days thereby forgoing cash discount.

Cost of forgoing discount in rupees = Discount × Selling price (a)

Financing recd. if discount is taken = (100 – Discount) Price (b)

Rate per period =Financing received

Rupee cost

= PD

PD

( 100 )–

×

=

D

D

100 –

Financing period = Payment period – Discount period (c)

No. of periods per year = Financingperiod

Days per year

=

Payment period–discount period

365

(d)

Annual interest rate = Rate per period × No. of periods

= Pay period–discount period

365

100

×

−D

D

Effective cost of discount =

TND

D

−

×

−

365

1

where D= Discount in decimal form,
N= Credit period, and
T= Discount period.

Effective cost of discount =

1045

365

.01 02

.0 02

−

×

−

= 21.2 percent

The company should accept the discount, as the cost of not taking the discount (21.2 percent) is much
higher than the cost of short-term funds (11 percent). It will be better off borrowing short-term at 11 percent,
and taking the discount.

CREDIT STANDARDS

Credit standards are norms prescribed by the company and pertaining to the creditworthiness of its customers.
One company may have the policy of extending credit to only those customers with the highest credit rating.