[Anonymous]

I am having trouble understanding the forumla and results for the concept of the Cost of Not Taking the Discount with regard to Trade Credit Discounts. For example, take the following question:

A company offers you Trade Credit Terms of 3/15 Net 45. What is the cost of NOT taking the trade credit discount and always paying between 15 and 45 days?

I see the formula to calculate this is:

(Discount% / (100% – Discount%)) * (365 / (total pay period – discount period))

So, for the above example, the formula would result in:

(3 / 97) * 360 / (45-15) = 37.6%

So, it looks this is trying to arguing that by not taking the discount it is costing us 37.6%? How? It would seem to me that if we do not take the discount, then we are simply losing the 2% discount we would have on everything we bought with them.

[GV]

The first part 3/97 tells you the non-annualized interest rate e.g. it will cost $3 to borrow $97 or 3.09%.

The (45-15) part tells you how many days you are borrowing the money for or 30 days.

It is costing 3.09% each 30 days.

To annualize this amount you have to figure out how many 30 day periods there are in a year.

Assuming 360 days in the year there are 12, 30 day periods or (360/30).

If you pay 3.09 in one period then you will pay 37.08% in 12 periods (3.09*12).

37.08% is the annualized rate. This is assuming you pay exactly on day 45.

If the payment is actually made before day 45, the effective annualized interest rate will actually be higher.
For example if the payment is made on day 30, the effective interest rate is
(3/97)*360/(30-15) = 74.16%!

On the flip side, if there are no additional penalties for paying after day 45 the interest rate is lower. For example, if you put off payment until day 60 and the vendor does nothing to enforce their payment guideline, the effective interest rate then becomes 24.7%.
(3/97)*360/(60-15) = 24.7%

GV

[Author]

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