Lexus Company - Cost of Trade Credit

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):

1. Forgo cash discounts granted on a basis of 2/10 net 30 and pay on the final due date.
2. Borrow $5 million from a bank at 15% interest on discount basis. This alternative would necessitate maintaining a 12% compensating balance.
3. 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