In real life, some companies often use short-term borrowing funds from bank to buy raw material to produce finished goods, and then sell to their customer on credit. They don’t use overdraft, just use loan finance. So, instead of using overdaft interest to compare with effective annual cost to decide whether or not offer the discount, can we use loan interest to compare with effective annual cost to offer the discount to our customer?

Furthermore, can we use deposit interest to compare with effective annual cost to offer the discount because we get money earlier then we deposit them in bank to receive interest.

Short-term borrowing is the same as an overdraft.
Loan finance in the exam always refers to long-term borrowing.

If the business has an overdraft then we use the overdraft interest rate, if on the other hand they have surplus cash then the interest being earned on the cash is the relevant interest rate – it is an opportunity cost.

Mr Moffat, would the examiner want to see our calculation of the effective rate of the cost or can we just say “the cost of giving a discount of e.g. 4% is 4.1667%? If this would be allowed it could save time in the exam if I would prepare a table for the rate of costs for different discount rates and memorize it. When I go through past papers I think I should fairly easily see which discount rates the examiner usually chooses. Obviously if he comes up with one not in my table I would have to calculate it in the exam.

hi John,
I just want to ask that if we do it this way for example 1:-
that for every $96 we get two months earlier, it costs us $4 i.e. 4.17%, while the benefit we get on receiving the payment 2 months earlier, i.e. the interest saved, is $3.2 {(20%/12) x 2} = 3.33%. So 3.33% of 96 is 3.2, thus comparing the cost & benefit, the amount it costs us to offer discount is higher than the interest we are saving by offering it.
Is it right to do it this way?

I am a bit confused about the answer we get in this way i.e. 27.75%, I understand the concept of effective rate and I agree that sales of 12m are not relevant in calculation as we don’t know how many customers are going to take discount, my question is that if we multiply 27.75% with any number of sales, for example if 50% of the customers availed discount i.e 6m, we should get the cost of discount i.e. 0.24m, by multiplying 6 with 27.75% as it is the annual cost of discount?
What i’m not getting is that how can we prove that 27.75% will be the cost of discount we have to bear, given any number of sales (customers) that availed discount?

If anyone were to take up the discount then it would effectively be costing us 27.75% on whatever money we got in sooner. We can then compare this with the interest rate on the overdraft to decide whether or not it was beneficial to us to offer it.

It doesn’t matter whether 1 customer decided to take the discount or all the customers decided to take it – if the cost of giving it in % terms is less that the overdraft interest rate then it is worth offering, it is is more then it is not worth offering.

(Sorry for troubling you again)
Lets say if half of the customers take discount, the money we’ll be getting in sooner is 5.76m (6m x 0.96), thus costing us 0.24m (6m-5.76), but taking 27.75% of 5.76 does not give us 0.24, why is that so?
Thanks alot 🙂

It is costing 0.24 for every 5.76 we get in early, which is 0.24/5.76 = 0.041666 (or 4.1666%) every 2 months.
Therefore the annual cost = 1.04166^ (12/2) – 1 = 0.2775 (or 27.75%).

May you please help me understand the logic behind calculations of the effective annual cost of discount. For instance, in the first example, why do we have to say 4/96 and also, why do we have to introduce 1+R in the calculations or that is just how the fomulae is like.

Sir I understand the logic and the calculations, but I just cannot seem to get these to work on my calculator? Can you help at all please! This is really frustrating, I’m sure once I have cracked it, it’ll get there but I just cant come up with the answer no matter which way I bloody do it!

I didn’t understand the logic of the calculations we made to obtain the effective annual cost. In fact, i don’t even think I got the idea of effective cost. Could you please clarify Mr.Moffat?

I am sorry but I really do not know what else to say other than what I say in the lecture (and I can’t type out the whole lecture here).
Please watch the lecture again and say which bit of it you are getting lost on.

I just need to understand the logic of the calculations, like in the example , we did (1.41667)^12/2. I do understand that 2 corresponds to 2 months and 12 to 1 year. But why did we put it as a power instead of for example, multiplying it or something. I’m sorry I am very bad at expressing myself. I just don’t understand the logic behind calculations. For example, to find EOQ i know the step by step logic of how to get that formula ( differentiation etc) but here it’s not clear. I hope you understand what’s worrying me

Both of the problems you mention are in fact revision from paper F2 and so it will help you to watch the relevant F2 lectures.

Deriving the EOQ formula cannot be asked (as I say in the lecture), which is why the formula is given on the formula sheet.

With regard to the interest, to add on 2% interest we multiply by 1.02. ($100 with 2% interest grows to $102).
Since the interest is added on every 2 months, it will be added on 6 times over the year. So we multiply by 1.02 six times (which is multiplying by 1.02^6)

Thanks a lot Mr. Moffat. I like to learn the logic behind every calculation so that i don’t need to learn anything by heart. As for the EOQ formula, I already understood it even if I know that it won’t be needed. Thanks for your clarifications it was very helpful !!!! 🙂

In order to determine whether or not to give the discount why are we comparing the effective annual cost with the bank overhead rate? I mean why is the bank overhead rate important in this case.

For calculating discount, is it acceptable to go say, (1/99) * (365/20)

Assuming a 1% discount and a reduction of 50 to 30 days (20 days less). I get 18.4% using this. I note that in the lecture you are getting around 20%. Will either method be accepted.

Thank you so much for the excellent videos too. It cannot be put into words how thankful I am.

In the past the examiner did used to accept the way you have done it.
However, because of MCQ’s, you should now do it the ‘correct’ way ( 1/99^(365/20) )

No. Factoring is more of a long-term policy applying to all receivables. Invoice discounting is a one-off exercise on one invoice as a way of getting short-term money when there is a cash flow problem.

In our BPP revision kit under investment appraisal we have a question (Q 49) involving advance annuity (starting at T0) and their corporation tax consequences. could you please explain how to deal with such a question.

Please ask this question in the Ask the Tutor Forum for Paper F9, and not as a comment on a lecture about something completely different!

Have you watched the lectures on investment appraisal, because dealing with annuities starting at a time different from time 1 and dealing with tax are all dealt with (and lease and buy is a particular example of an annuity starting at time 0).

Good day sir,
Thank you for the lectures,based on the example in the lecture notes,can i use the 12m sales figure to solve the question which gives me approx. 21%.as the discount to be offered?

The $12M is not relevant. The reason is that although we might offer a discount, we can not force customers to pay early and take advantage of it. We might hope we will (and therefore we might offer the discount) but again, we have no idea how many of the customers will take it.

khanhhoangvu says

Dear Teacher

In real life, some companies often use short-term borrowing funds from bank to buy raw material to produce finished goods, and then sell to their customer on credit. They don’t use overdraft, just use loan finance. So, instead of using overdaft interest to compare with effective annual cost to decide whether or not offer the discount, can we use loan interest to compare with effective annual cost to offer the discount to our customer?

Furthermore, can we use deposit interest to compare with effective annual cost to offer the discount because we get money earlier then we deposit them in bank to receive interest.

Could you please help me to explain more clearly.

Thank you very for your lecture and your help.

John Moffat says

Short-term borrowing is the same as an overdraft.

Loan finance in the exam always refers to long-term borrowing.

If the business has an overdraft then we use the overdraft interest rate, if on the other hand they have surplus cash then the interest being earned on the cash is the relevant interest rate – it is an opportunity cost.

Lebogang says

Hi Sir

how can one download this videos…

Auret says

Mr Moffat, would the examiner want to see our calculation of the effective rate of the cost or can we just say “the cost of giving a discount of e.g. 4% is 4.1667%? If this would be allowed it could save time in the exam if I would prepare a table for the rate of costs for different discount rates and memorize it. When I go through past papers I think I should fairly easily see which discount rates the examiner usually chooses. Obviously if he comes up with one not in my table I would have to calculate it in the exam.

John Moffat says

In Section B, you must show your workings – it is the workings that are marked, not the final answer.

In Section A (the MCQ’s) nobody will look at your workings so it does not matter how you arrived at the answer.

Auret says

Thank you sir.

John Moffat says

You are welcome 🙂

Mahrukh says

hi John,

I just want to ask that if we do it this way for example 1:-

that for every $96 we get two months earlier, it costs us $4 i.e. 4.17%, while the benefit we get on receiving the payment 2 months earlier, i.e. the interest saved, is $3.2 {(20%/12) x 2} = 3.33%. So 3.33% of 96 is 3.2, thus comparing the cost & benefit, the amount it costs us to offer discount is higher than the interest we are saving by offering it.

Is it right to do it this way?

John Moffat says

No – what is in the lecture is the correct way 🙂

Mahrukh says

I am a bit confused about the answer we get in this way i.e. 27.75%, I understand the concept of effective rate and I agree that sales of 12m are not relevant in calculation as we don’t know how many customers are going to take discount, my question is that if we multiply 27.75% with any number of sales, for example if 50% of the customers availed discount i.e 6m, we should get the cost of discount i.e. 0.24m, by multiplying 6 with 27.75% as it is the annual cost of discount?

What i’m not getting is that how can we prove that 27.75% will be the cost of discount we have to bear, given any number of sales (customers) that availed discount?

John Moffat says

If anyone were to take up the discount then it would effectively be costing us 27.75% on whatever money we got in sooner. We can then compare this with the interest rate on the overdraft to decide whether or not it was beneficial to us to offer it.

It doesn’t matter whether 1 customer decided to take the discount or all the customers decided to take it – if the cost of giving it in % terms is less that the overdraft interest rate then it is worth offering, it is is more then it is not worth offering.

Mahrukh says

(Sorry for troubling you again)

Lets say if half of the customers take discount, the money we’ll be getting in sooner is 5.76m (6m x 0.96), thus costing us 0.24m (6m-5.76), but taking 27.75% of 5.76 does not give us 0.24, why is that so?

Thanks alot 🙂

John Moffat says

Of course not!

It is costing 0.24 for every 5.76 we get in early, which is 0.24/5.76 = 0.041666 (or 4.1666%) every 2 months.

Therefore the annual cost = 1.04166^ (12/2) – 1 = 0.2775 (or 27.75%).

Mahrukh says

Thankyou 🙂

John Moffat says

You are welcome 🙂

Joyce says

Hi John

May you please help me understand the logic behind calculations of the effective annual cost of discount. For instance, in the first example, why do we have to say 4/96 and also, why do we have to introduce 1+R in the calculations or that is just how the fomulae is like.

John Moffat says

This is all explained in the lectures. For every 100 invoiced, then a discount of 4% will mean only 96 is received.

Therefore the cost of getting 96 early is 4, or effectively 4/96%

Chris says

Sir I understand the logic and the calculations, but I just cannot seem to get these to work on my calculator? Can you help at all please! This is really frustrating, I’m sure once I have cracked it, it’ll get there but I just cant come up with the answer no matter which way I bloody do it!

Thanks, Chris.

Martynas says

Hi John,

Just a quick question in regards to effective rate: could you advice why do we take 99 as a denominator instead of 100?

As I see it if we have a product which costs 4 and we offer a discount of 2, the effective rate is 4/2=50%, I dont get how it can be 2/2=100%

thanks a lot, marty

John Moffat says

The discount is 1% (not $1!). So for every 100 invoiced, the discount is 1 and the amount payable is 99.

shaafia says

I didn’t understand the logic of the calculations we made to obtain the effective annual cost. In fact, i don’t even think I got the idea of effective cost. Could you please clarify Mr.Moffat?

John Moffat says

I am sorry but I really do not know what else to say other than what I say in the lecture (and I can’t type out the whole lecture here).

Please watch the lecture again and say which bit of it you are getting lost on.

shaafia says

I just need to understand the logic of the calculations, like in the example , we did (1.41667)^12/2. I do understand that 2 corresponds to 2 months and 12 to 1 year. But why did we put it as a power instead of for example, multiplying it or something. I’m sorry I am very bad at expressing myself. I just don’t understand the logic behind calculations. For example, to find EOQ i know the step by step logic of how to get that formula ( differentiation etc) but here it’s not clear. I hope you understand what’s worrying me

John Moffat says

Both of the problems you mention are in fact revision from paper F2 and so it will help you to watch the relevant F2 lectures.

Deriving the EOQ formula cannot be asked (as I say in the lecture), which is why the formula is given on the formula sheet.

With regard to the interest, to add on 2% interest we multiply by 1.02. ($100 with 2% interest grows to $102).

Since the interest is added on every 2 months, it will be added on 6 times over the year. So we multiply by 1.02 six times (which is multiplying by 1.02^6)

shaafia says

Thanks a lot Mr. Moffat. I like to learn the logic behind every calculation so that i don’t need to learn anything by heart. As for the EOQ formula, I already understood it even if I know that it won’t be needed. Thanks for your clarifications it was very helpful !!!! 🙂

John Moffat says

You are welcome 🙂

Arun says

Hello John,

In order to determine whether or not to give the discount why are we comparing the effective annual cost with the bank overhead rate? I mean why is the bank overhead rate important in this case.

Thanks,

Arun.

John Moffat says

It is the bank overdraft rate (not the bank overhead rate), which is the interest charged by the bank on negative balances (i.e. on borrowings).

If receivables pay us sooner then the level of bank borrowings needed (the overdraft) will be lower, and therefore we will save bank interest.

aanaa says

sir,how do we calculate effective annual cost in$????

John Moffat says

Effective annual cost is not calculated in $’s – it is a %.

aanaa says

Thank you sir!

Gary says

For calculating discount, is it acceptable to go say, (1/99) * (365/20)

Assuming a 1% discount and a reduction of 50 to 30 days (20 days less). I get 18.4% using this. I note that in the lecture you are getting around 20%. Will either method be accepted.

Thank you so much for the excellent videos too. It cannot be put into words how thankful I am.

John Moffat says

In the past the examiner did used to accept the way you have done it.

However, because of MCQ’s, you should now do it the ‘correct’ way ( 1/99^(365/20) )

Alick says

Dear John,

Is invoice discounting a kind of factoring method?

Thanks!

John Moffat says

No. Factoring is more of a long-term policy applying to all receivables. Invoice discounting is a one-off exercise on one invoice as a way of getting short-term money when there is a cash flow problem.

Alick says

Thank you John!

Have a nice day!

alifahumee says

Dear John Sir,

In our BPP revision kit under investment appraisal we have a question (Q 49) involving advance annuity (starting at T0) and their corporation tax consequences. could you please explain how to deal with such a question.

Thank you

John Moffat says

Please ask this question in the Ask the Tutor Forum for Paper F9, and not as a comment on a lecture about something completely different!

Have you watched the lectures on investment appraisal, because dealing with annuities starting at a time different from time 1 and dealing with tax are all dealt with (and lease and buy is a particular example of an annuity starting at time 0).

mehreen245 says

hi Mr Moffat

at 18:24 you said difference of 500 is cost for us for getting it now.. did you mean 100{5000-4900}?

John Moffat says

Ooops – yes 🙂

The cost is 100, not 500. Sorry 🙂

aliimranacca007 says

1 + R = 1.04166 how 1.041667 come

John Moffat says

R = 4/96 = 4.1667% or 0.041667

1+R = 1 + 0.041667 = 1.041667

Samoar says

The new upgrade for the video lectures looks great and is more helpful than the last format. 🙂

Abel says

Thanks this is helpful

yetunde says

Good day sir,

Thank you for the lectures,based on the example in the lecture notes,can i use the 12m sales figure to solve the question which gives me approx. 21%.as the discount to be offered?

John Moffat says

The $12M is not relevant. The reason is that although we might offer a discount, we can not force customers to pay early and take advantage of it. We might hope we will (and therefore we might offer the discount) but again, we have no idea how many of the customers will take it.