A general contractor is reviewing vendor payment terms. Vendor A offers 2/10, net 30 terms. Vendor B offers net 15 terms. For a $10,000 purchase, what is the effective annual interest rate if the contractor takes Vendor A's discount?
Correct Answer
C) 36.7%
The discount is 2% for paying 20 days early (day 10 vs day 30). Effective rate = (2% ÷ 98%) × (365 ÷ 20) = 2.04% × 18.25 = 36.7% annual rate. This shows the high cost of not taking early payment discounts.
Why This Is the Correct Answer
The effective annual interest rate calculation correctly determines the cost of not taking the early payment discount. The formula accounts for the discount percentage (2%), the net amount paid (98%), and annualizes the rate by considering how many 20-day periods occur in a year (365÷20 = 18.25). This 36.7% rate represents the extremely high cost of foregoing the early payment discount, making it financially advantageous to take the discount even if borrowing money is required.
Why the Other Options Are Wrong
Option A: 24.5%
18.2% significantly underestimates the effective annual rate, possibly from using an incorrect time period in the calculation or failing to properly account for the discount being taken against the net payment amount rather than the gross amount.
Option B: 18.2%
24.5% underestimates the effective annual rate because it likely uses an incorrect calculation method, possibly using simple interest rather than the proper effective rate formula that accounts for the net payment amount (98% rather than 100%).
Option D: 2.0%
2.0% only represents the nominal discount percentage offered, not the effective annual interest rate. This fails to account for the time value of money and the fact that the discount is earned over just 20 days, which when annualized becomes much higher.
Memory Technique
Remember 'D-NET-TIME': Discount percentage divided by NET payment percentage, then multiply by TIME factor (365 divided by days saved)
Reference Hint
Business and Finance chapter covering cash flow management, payment terms, and time value of money calculations
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