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Hi John,
A company has sales of 200M per year.
Currently on average customers take 40 days to pay.
The company is considering offering a discount of 1% for payment within 15 days and expects that 60% of the customers will take advantage of the discount.What is the Effective Annual Cost of offering the discount?
a) 15.80%
b) 9.22%
c)15.63%
d) 9.13%60%*15+40%*40 = 25 days,
therefore with discount, we will shorten receivable days by 40-25= 15 days.( (1 + 1/99) ^ (365/15) ) – 1 = 0.277
There is not one answer of 27.7%. Many thanks.
When calculating the cost of the discount as a %, it is irrelevant how many people end up actually taking the discount. If the % cost is less than the cost of overdraft interest then it is worth offering (however many people end up taking it), whereas if it is more than the cost of overdraft interest it is not worth offering.
Therefore the effective annual cost of a 1% discount for paying 25 days early is (1 + 1/99)^(365/25) – 1 = 0.158 (15.8%)
I do suggest that you watch our free lectures – this is mentioned in the lecture working though example 1 of the relevant chapter.
(Our lectures are a complete course for Paper F9 and cover everything needed to be able to pass the exam well)
Thank you for your reply.
If it is irrelevant how many people end up taking the discount. Why can’t I calculate example 2 of chapter 5 in the following way?
Current receivable days: 30*20% + 60*50% + 90* 30% = 63 days
Offer discount 1% for payment within 30 days.
(1+1/99)^ 365/(63-30)-1 = 11.76% < 15%
Should offer discount. (which is wrong)
Because in example 2, you are not asked for the % cost – you are asked for the net cost or benefit.
Again, I do explain the reason for the different approach in the lectures. You should not use the lecture notes on their own – it is in the lectures that we explain and expand on the notes.
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