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Why is the opportunity cost calculated in this problem based on the initial invoice amount instead of the discounted amount which would be financed if the discount is accepted?
Kaplan
PG.285 TU 5
One supplier has offered a discount to Box Co of 2% on an invoice for
$7,500, if payment is made within one month, rather than the three
months normally taken to pay. If Box’s overdraft rate is 10% pa, is it
financially worthwhile for them to accept the discount and pay early?Answer:
Discount saves 2% of $7,500 =$150
Financed by overdraft for extra two months in order to pay earlyCost =
Net saving
It is worth accepting the discount.
10% × 2/12 × $7,500 = ($125)
ALTERNATIVELY
Discount as a percentage of amount paid
Saving is 2 months and there are 6 periods in a yearAnnualised cost of not taking the discount =150/7350 2.04%
(and therefore borrowing from the supplier) isThe overdraft rate is 10%.
(1 + 0.0204)^6 – 1 12.88%
It would be cheaper to borrow the money from the bank to pay early and
accept the discount.It has been when calculating the cost of the discount (it has been calculated correctly on 7,350).
If they don’t take the discount then they pay the full 7,500 and the overdraft rate will apply to the full amount paid early.
I saw it as 2 separate scenarios:
1) don’t take the discount – supplier finances you for the 3 months set out initially (for free – 90 days agreement payment).
2) gain 150 $ from discount, overdraft cost on 7350*10%*2/12 months.Why isn’t this the opportunity cost? I will need to finance 7350$ if I take the discount not 7500$. In no situation I will ever need to finance 7500$. It’s either 0 or 7350.
What is wrong with my thinking?
Thank you,
MihaiNo. If you do not take the discount then they have the cost of financing the full 7,500 that they have to pay, at 10%.
Have you watched my free lectures on the management of receivables and payables?
The lectures are a complete free course for Paper F9 and cover everything needed to be able to pass the exam well.
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