Cost of Trade Credit

Lexus Company has extended 900 of trade credit to a customer on terms of ”2/10, net/30.” The
customer can either pay 900 × 98% = 882 at the end of the 10 day discount period, or wait for
the full 30 days and pay the full 900. By waiting the full 30 days, the customer effectively
borrows 882 for an additional 20 days, paying 900 – 882 or 18 in interest.

With the above information, the credit cost of borrowing this money can be computed as
follows:

Cost of Credit
= [Percent Discount/(100 – Percent of Discount)] x [360/(credit period – discount period)]
= [2/(100-2)] x [(360/(30-10)]
= 2/98 x 360/20
= 0.367347

As per this example, the annual percentage cost of offering a “2/10, net/ 30” trade discount is
almost 36.7347%.

Annualizing The Credit Cost

The 20-day discount period occurs 18 times per year. Using this information, it is possible to
compute the effective annual rate of interest on a 360-day year:

Effective Annual Credit Cost

= [1+ r/m)m – 1
= [1 + (.367347/18)]18 – 1
= 0.438568

Annualized, the 36.73 percent cost of interest amounts to a substantial 43.8568 percent.

Some examples of additional credit costs are illustrated below:

Credit terms
Discount Days Net Percent Annualized
1 10 20 36.36% 43.59%
1 10 30 18.18% 19.88%
2 10 20 73.47% 106.96%
2 10 30 36.73% 44.12%
3 10 20 111.34% 199.38%
3 10 30 55.67% 73.75%
 A company needs to increase its working capital by $4.4 million. The following three
financing alternatives are available (assume a 365-day year):

a. Forgo cash discounts granted on a basis of 2/10 net 30 and pay on the final due date.
b. Borrow $5 million from a bank at 15% interest on discount basis. This alternative
would necessitate maintaining a 12% compensating balance.
c. Issue $4.7 million of three-month commercial paper to net $4.2 million. Assume that
new paper would be issued every three months.

Zen Inc. wants to raise working capital by Tk.1 crore. It has following four alternative
sources:
a. Forgo cash discounts granted on a basis of 3/10 net 60 and pay on the final due date.
b. Borrow from National Bank @15% interest per annum. This alternative would
necessitate maintaining a 13% compensating balance.
c. Issuing commercial paper @12% interest per annum and floatation cost of 1%
d. Issuing commercial paper with face value Tk.1,08,00,000 and sale value of Tk.
1,00,00,000 for six months. Cost of issue Tk.50,000 per issue.
Which is the cheapest alternative?
Accounts Receivables Financing Cost
EIR = Annual Interest or Annual Factoring Cost / Net Loan Amount

A/R Turnover = Total Credit Sales / Average A/R Balance

Average Duration of Loan = 360 days / A/R Turnover

Reserve or Margin Amount = Average loan i.e. average A/R balance x Reserve
or Margin percentage

Usable loan amount = Average loan balance i.e. average A/R balance - Reserve
or Margin Amount - Periodic factoring commission

Annual Factoring Cost = Annual Interest + Annual Factoring Commission -

Amount of Bad Debt Loss (if any) – A/R Admin. Cost

Net Loan Amount = Average loan balance i.e. average A/R balance - Reserve
or Margin Amount - Periodic factoring commission - Periodic
Interest Amount

Notes: Factoring commission percentage should be applied on the average A/R balance
to determine the periodic factoring commission
 Bad debt percentage should be applied on the total credit sales

Periodic Interest Amount = Periodic Interest Rate x Usable loan amount

A company has annual credit sales of Tk.10 lac and its average A/R balance is Tk.2 lac.
Therefore, average collection period is 72 days. The company is considering taking loan
from a bank by assigning A/R @16% per annum up to 80% of the face value of A/R. What
is the effective interest rate?

If in the above problem, the company has to pay factoring commission of 2% and if there is
a bad debt loss of 2.5%, then what is the effective interest rate?
A company has annual credit sales of Tk.20 crore and its average A/R balance is Tk.5 crore.
The company is considering taking loan from bank by pledging A/R @16% per annum. The
bank requires 20% margin on the face value of A/R. Find the effective interest rate.
A company has annual credit sales of Tk.80 lac and its average collection period of 90 days.
It's bad debt loss is 1%. A/R administration cost is Tk.1,20,000 per year. A factor has agreed
to purchase the company's A/R @18% per annum with a 2% factoring commission and 10%
reserve on the face value of A/R. Find the total factoring cost and effective interest rate.