Many creditors of your firm offer early payment discounts. The accounts payable supervisor does not believe in paying early “as the bank overdraft rate of j12 = 8% pa is more than the average 2% offered for payment within 10 days from date of invoice”. The supervisor stretches the accounts to 40 days from the last date of early payment discount. If average creditors terms are 2%, 10: net 30, what is the minimum number of days beyond the net date that accounts must be stretched to make stretching a viable alternative?
Well done
To determine the minimum number of days beyond the net date that accounts must be stretched to make stretching a viable alternative, we need to compare the cost of stretching accounts to the cost of paying early.
Given information:
- Early payment discount: 2%
- Early payment discount period: 10 days from the date of the invoice
- Net payment period: 30 days from the date of the invoice
- Overdraft rate: 8% per annum
To make stretching a viable alternative, the cost of stretching accounts beyond the net date should be less than the cost of the early payment discount.
Let's calculate the cost of stretching accounts beyond the net date:
1. Calculate the cost of stretching for 40 days (10 days beyond the net date):
Cost of stretching = Overdraft rate * Accounts payable * (Number of days stretched/365)
Cost of stretching = 8% * 100 * (40/365)
Cost of stretching = 8 * 100 * (40/365)
Cost of stretching = 87.67
2. Compare the cost of stretching to the discount percentage:
If the cost of stretching (87.67) is less than the early payment discount (2%), then stretching is a viable alternative.
Therefore, the minimum number of days beyond the net date that accounts must be stretched is 40 days.
To determine the minimum number of days beyond the net date that accounts must be stretched in order to make stretching a viable alternative, we need to compare the cost of stretching accounts to the cost of taking advantage of the early payment discount.
First, let's calculate the cost of stretching the accounts to 40 days from the last date of early payment discount. Given the average creditors terms of 2%, 10: net 30, it means that the net payment is due 30 days from the date of the invoice.
To calculate the cost of stretching, we need to consider the interest rate on the overdraft and the interest rate offered for early payment.
1. Calculate the interest cost of stretching accounts:
Bank overdraft rate annualized = 8% per year
Daily interest rate for overdraft = bank overdraft rate / 365 = 8% / 365 = 0.0219% per day
The accounts are stretched to 40 days from the last date of the early payment discount. So, calculate the interest cost for stretching:
Interest cost of stretching = daily interest rate for overdraft * number of days stretched
Interest cost of stretching = 0.0219% * 40 = 0.876%
2. Calculate the interest earned for early payment:
Early payment discount rate = 2% per invoice
Annual discount rate = early payment discount rate / (1 - early payment discount rate) = 2% / (1 - 2%) = 2% / 0.98 = 2.04% per year
Daily interest rate for early payment = annual discount rate / 365 = 2.04% / 365 = 0.0056% per day
The accounts are paid within 10 days from the date of the invoice to take advantage of the early payment discount. So, calculate the interest earned:
Interest earned for early payment = daily interest rate for early payment * number of days to take advantage of the discount
Interest earned for early payment = 0.0056% * 10 = 0.056%
Now, we can compare the cost of stretching accounts (0.876%) with the interest earned for early payment (0.056%).
Since the cost of stretching (0.876%) is higher than the interest earned for early payment (0.056%), stretching accounts to 40 days from the last date of the early payment discount is not a viable alternative.
Therefore, in order to make stretching a viable alternative, the accounts must be stretched beyond the net date by more than 40 days.