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Unformatted text preview: h discount on its February 27 purchase by paying $980 on March 10. If Lawrence gives up the cash discount, payment can be made on March 30. To keep its money for an extra 20 days, the firm must give up an opportunity to pay $980 for its $1,000 purchase. In other words, it will cost the firm $20 to delay payment for 20 days. Figure 15.1 shows the payment options that are open to the company. To calculate the cost of giving up the cash discount, the true purchase price must be viewed as the discounted cost of the merchandise, which is $980 for 638 PART 5 Short-Term Financial Decisions FIGURE 15.1 Firm Makes $1,000 Purchase Cash Discount Period Ends; Pay $980 Credit Period Ends; Pay $1,000 Mar. 10 Payment Options Payment options for Lawrence Industries Mar. 30 Credit Period Begins Feb. 27 Mar. 1 Cost of Additional 20 Days = $1,000 – $980 = $20 Lawrence Industries. The annual percentage cost of giving up the cash discount can be calculated using Equation 15.1:1 Cost of giving up cash discount CD 100% CD 360 N (15.1) where CD N stated cash discount in percentage terms number of days that payment can be delayed by giving up the cash discount Substituting the values for CD (2%) and N (20 days) into Equation 15.1 results in an annualized cost of giving up the cash discount of 36.73% [(2% 98%) (360 20)]. A 360-day year is assumed.2 A simple way to approximate the cost of giving up a cash discount is to use the stated cash discount percentage, CD, in place of the first term of Equation 15.1: Approximate cost of giving up cash discount 360 N CD (15.2) 1. Equation 15.1 and the related discussions are based on the assumption that only one discount is offered. In the event that multiple discounts are offered, calculation of the cost of giving up the discount must be made for each alternative. 2. This example assumes that Lawrence Industries gives up only one discount during the year, which costs it 2.04% for 20 days (that is, 2% 98%) or 36.73% when annualized. However, if Lawrence Industries continually gives up the 2% cash discounts, the effect of compounding...
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This document was uploaded on 01/19/2014.

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