CFA Level ICorporate IssuersHard
A supplier offers a manufacturer credit terms of '2/10, net 45.' If the manufacturer forgoes the discount and pays on day 45, what is the approximate annualized cost of trade credit (using a 365-day year)?
- A24.3%
- B21.3%
- C20.9%
- D14.9%
Show answer & explanationAnswer & explanation
Correct answer: B. 21.3%
Cost of trade credit = [discount % / (1 − discount %)] × [365 / (days paid − discount period)] = (0.02/0.98) × (365/35) = 0.020408 × 10.4286 ≈ 0.213, or 21.3%.
Why the other options are wrong
- A. Overstates the cost by using an incorrect number of discount-forgone days.
- C. Omits dividing by (1 − discount %), understating the true cost.
- D. Understates the cost by using an incorrect payment period.
Cost of Trade Credit
The implicit annualized interest rate a firm pays by forgoing a supplier's early payment discount and paying at the end of the credit period instead.
- Formula: [d/(1−d)] × [365/(days paid − discount days)]
- Forgoing discounts often implies a very high effective borrowing cost
- Terms like '2/10, net 45' mean a 2% discount if paid within 10 days, otherwise full amount due in 45 days
Memory trick: Skip the discount, pay a steep hidden interest rate