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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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