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Question 42.
D Co decides to offer 2% early discount that half of the customers take up. They pay in one month instead of the usual two. D Co pays 10% per annum for its overdraft.
What impact will this have
Cash Operating cycle Reporting Profits
a. reduce increaseb. unaffected increase
c. reduce reduce
d. unaffected reduce
I know the operating cycle will reduce since by customers taking up the early settlement discount this reduces the receivables thereby reducing the working capital cycle. My issue is with the profits section
i tried using the (100/100-discount)^365/t -1 formula to get the cost of the discount and compare it to the overdraft facility. but i am confused on how to apply the 50% of customers taking the discount, do i apply it on the 2 percent directly and get 1 percent and input that into the formula which gave me
(100/99)^365/31 -1= 12.6%
I just looked at the answer more closely it says the cost of discount is 2% per month hence leading to reduced profit which is completely different from my answer
please can someone explain this
But the answer in the Revision Kit is not completely different!!
It actually says that the interest saved on the overdraft is less than the 1% per month cost of giving the discount. This is exactly what you have proved above – it is cheaper to have the overdraft and only pay 10% than to offer the discount at a cost of 12.6%.
Therefore, if they do offer the discount it will be costing them more and the profit will reduce.
(Incidentally, you have done a little more work then is actually necessary to be able to answer the question, since it didn’t ask for a calculation. With 12 months in a year, the annual cost of offering the discount must be more than 12 x 1% (because of compounding) and is therefore automatically costing more than the 10% cost of the overdraft).
Thank you
Its the first time I’ve seen compounding for the year with a cost of discount question. The 2% cost of discount per month in the answer is what confuses me. So if i have your explanation right, there is no need to use the cost of discount formula and just instead compound annually using 12 x 1% which is a higher cost than the overdraft thereby reducing profits.
12 x 1% is not compounding! Compounding is doing what you did in arriving at 12.6%.
My point is that since they did not ask for the exact cost (12.6%) it should be obvious from the start because the exact cost is bound to be more than 12% (and that is already more than 10%).
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