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I have a question.. In the lecture relating to chapter 5 example 1 (Early settlement discounts)it more or less states that the cost of early settlement discount is calculated by the following formula: D/100-D multiplied by 365/reduction in payment period(in days).
However, in my text book it gives the formula 1-(100/(100-D) TO THE POWER OF 365/reduction in payment period(in days).
I can see that the fist part of the formula is more or less the same, but why is it in the example in my book it states the formula is to the power of instead of multiplied by 365/reduction in payment period(in days).
Are they refering to the same thing?.. because they both give different answers! I am confused!
Thanks
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The choice when calculating the effective annual cost of the discount is to either adopt a SIMPLE INTEREST approach or to calculate the effective cost of the discount using a COMPOUND INTEREST approach. Both, approaches will lead to different answers and of course compounding the interest rate (POWER) will always lead to a higher figure.
In the case of example 1 the customer is essentially giving you a loan of
$11,520,000 for 60 days at a cost of $480,000 – so either gross this 60 day loan up by either multiplying (Simple Interest) or placing the appropriate factor as a power (Compound Interest) in order to find the effective annual cost of the loan (or rather discount!) .Hope this helps, Kind regards, Peter
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