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Unformatted text preview: will cause the annualized cost to rise to 43.84%:
Annualized cost when discounts
are continually given up 1 CD
100% CD 1 2%
100% 2% 360/N 360/20 1 (15.1a)
1 43.84% CHAPTER 15 Current Liabilities Management 639 The smaller the cash discount, the closer the approximation to the actual cost of
giving it up. Using this approximation, the cost of giving up the cash discount for
Lawrence Industries is 36% [2% (360 20)].
Using the Cost of Giving Up a Cash Discount in Decision Making The
financial manager must determine whether it is advisable to take a cash discount.
Financial managers must remember that taking cash discounts may represent an
important source of additional profitability.
EXAMPLE Mason Products, a large building-supply company, has four possible suppliers,
each offering different credit terms. Otherwise, their products and services are
identical. Table 15.1 presents the credit terms offered by suppliers A, B, C, and D
and the cost of giving up the cash discounts in each transaction. The approximation method of calculating the cost of giving up a cash discount (Equation 15.2)
has been used. The cost of giving up the cash discount from supplier A is 36%;
from supplier B, 8%; from supplier C, 21.6%; and from supplier D, 28.8%.
If the firm needs short-term funds, which it can borrow from its bank at an
interest rate of 13%, and if each of the suppliers is viewed separately, which (if
any) of the suppliers’ cash discounts will the firm give up? In dealing with supplier A, the firm takes the cash discount, because the cost of giving it up is 36%,
and then borrows the funds it requires from its bank at 13% interest. With supplier B, the firm would do better to give up the cash discount, because the cost of
this action is less than the cost of borrowing money from the bank (8% versus
13%). With either supplier C or supplier D, the firm should take the cash discount, because in both cases the cost of giving up the discount is greater than the
13% cost of borrowing from the bank.
The example shows that the cost of giving up a cash discount is relevant
when one is evaluating a single supplier’s credit terms in...
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